Trading Divergence and Understanding Momentum

As such, it is important to know when a trend is slowing down. Trading in the financial markets is associated with high investment risks. Hidden Bearish Divergence — when Stochastics are nearing overbought levels the pair falls immediately to continue the downtrend. The most important signal of the moving average convergence divergence is when the trigger line crosses the MACD up or down. However, the first one completely failed and the second one resulted in a massive winner. The email does not exist in out system. Understanding trend momentum gives a profit edge, as there are three ways to profit here:

Managing Divergence. Divergence is important for trade management. In Figure 5, taking profit or selling a call option were fine strategies. The divergence between the price and the indicator lead to a pullback, then the trend continued.

Momentum Indicators

Momentum indicators are commonly used to smooth out the price action and give a clearer picture. They allow the trader to compare the indicator swings to price swings, rather than having to compare price to price. Common momentum indicators for measuring price movements include the relative strength index RSI , stochastics and rate of change ROC. Figure 2 is an example of how RSI is used to measure momentum.

The default setting for RSI is RSI has fixed boundaries with values ranging from For each upswing in price, there is a similar upswing in RSI. When price swings down, RSI also swings down.

Getting Confirmation With the Momentum Strategy. Disagreement between the indicator and price is called divergence, and it can have significant implications for trade management. For this article, the discussion will be limited to the basic forms of divergence.

For more, see What does it mean to use technical divergence in trading? It is important to note there must be price swings of sufficient strength to make momentum analysis valid.

Therefore, momentum is useful in active trends, but it is not useful in range conditions in which price swings are limited and variable, as shown in Figure 4.

In a downtrend , divergence occurs when price makes a lower low, but the indicator does not. When divergence is spotted, there is a higher probability of a price retracement. Figure 5 is an example of divergence and not a reversal, but a change of trend direction to sideways. Divergence helps the trader recognize and react appropriately to a change in price action. It tells us something is changing and the trader must make a decision, such as tighten the stop-loss or take profit.

Seeing divergence increases profitability by alerting the trader to protect profits. Take note of the stock from Figure 5, Chesapeake Energy Corp. CHK , in which shares pulled back to the support. The chart of CHK in Figure 6 below shows trends do not reverse quickly, or often. Therefore, we make the best profits when we understand trend momentum and use it for the right strategy at the right time. Divergence is important for trade management. In Figure 5, taking profit or selling a call option were fine strategies.

The signal to enter appeared when the higher low in price agreed with the higher low of the indicator in Figure 6 small green arrows. Divergence indicates something is changing, but it does not mean the trend will reverse. It signals the trader must consider strategy options: The glamour of wanting to pick the top or bottom is more about ego than profits. To be consistently profitable is to pick the right strategy for what price is doing, not what we think price will do. Figure 7 shows divergence that leads to sideways price action.

Notice the weakening momentum in moving average convergence divergence MACD as price enters a range. This signals the trader should consider strategy options. When price and the indicator are inconsistent relative to each other, we have disagreement, or divergence. We are not in control of what price will do; we control only our own actions.

Sometimes divergence will lead to a trend reversal, as shown in Figure 8. XLU shown in Figure 9 pays a dividend and has options. Understanding trend momentum gives a profit edge, as there are three ways to profit here: In theory, prices and indicators are supposed to go in the same direction at equal rates. If price reaches a higher high, then the indicator is supposed to reach a higher high. If price reaches a lower high then the indicator is supposed to follow suit.

The same applies to lower lows and higher lows. In short, divergence is calculated between highs and lows of price and the indicators.

Applying this distinction, there are four basic types of divergence: We will explain each type and how to trade the corresponding divergence forex strategy.

Regular divergences are used as a tool to indicate reversals. This signals a possible reversal of the trend or at least a retrace of the downtrend.

Adding to this is the fact that the price was trading between 1. As we can see from the 4-hour chart, the price reached a high in the previous week and then made a higher high the following week. On the other hand, the MACD indicator at the bottom of the chart is making lower highs. In this case, since we are in an uptrend, we should expect a retracement. After entering at the top, we should look to get out of the trade at the uptrend line. Unlike regular divergence, hidden divergence indicates a continuation of the trend.

This divergence indicates that the retrace down is over and trend continuation is about to resume. We can see that when stochastic was nearing overbought levels and had established divergence with the price which made lower highs, the pair fell immediately and began a downtrend.

This is a bearish reversing signal. Divergence is quite easy to spot, as it only requires drawing a few lines. Nonetheless, sometimes we look too hard at the charts. The chart below shows a four-day consolidation period with indicators and the price not correlating exactly. However, this setup does not constitute a divergence.

MACD: principle and peculiarities

A divergence alone is not something that strong enough and many traders experience bad results when trading only with divergences. Just like any trading strategy, you need to add more confluence factors to make your strategy strong. Below we see how price made 2 divergences but price never sold off. Divergence Trading Strategy WHAT IS A DIVERGENCE? The answer starts with a simple comparison of price movement to practically any price based indicator or oscillator (i.e. MACD, Stochastic, CCI, RSI, etc,). A regular divergence occurs when price, in the case of a downtrend, is making lower lows, and the indicator is NOT. Oscillators like RSI, stochastics, and MACD are powerful tools if you know how to use them. Looking out for divergences is a part of using oscillators for trading. Divergence refers to the disagreement between price and the oscillator. Classic divergences are part of a reversal trading strategy. Hidden divergences point to continuation trades.