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How to trade Divergences
In this article I will explain you what divergence is and how to trade it. For trading divergences we need only Price Action and one indicator. The indicator might be an oscillator like the RSI or the stochastic, might be a momentum indicator like CCI or the Momentum or finally you can trade Volume divergences with a volume indicator.
First of all, I want to say what divergence is. When the traders say “divergence” mean a disagreement between Price Action Signals and Indicators Signals. Let’s see our first screen shot. It’s from USDJPY currency pair.
As you can see in this chart I use only a 14 period RSI. Look the price behavior in the blue box. It makes higher- highs. Now, look at the RSI behavior. It makes higher- highs, too. In this case the price action and the oscillator agree. There is not a divergence. Take a look in the second screen shot. It’s from AUDUSD currency pair.
In this case, you can easily see that the price makes Higher- Highs but our 14 period RSI makes lower- highs. So, we have a disagreement here and there is a divergence. With the price making HHs and the oscillator making LHs we have a sell signal. In this case we have a mini up-trend and it’s time for a big reversal of the trend. Notice that after the disagreement we have a big movement down and the price finally stops moving down in the support near the whole number (the yellow horizontal line). If there is an opposite condition in which the price makes lower- highs and our indicator higher- highs there is again a sell signal.
I said above when we have bearish signals. Now, I am going to say when there are bullish signals. Take a look. It’s from EURUSD currency pair.
The price in the blue box makes lower- lows. Our indicator in the blue box makes higher- lows. There is a small disagreement here so there is also a small bullish divergence. Notice the bullish movement of the price after the reversal. In the opposite condition in which price makes higher- lows and our indicator makes lower- lows there is again a bullish signals.
You can use the indicator you want. In the charts I use the RSI. Divergence is a very strong tool and you should look for hidden divergences regardless of the strategy you are using.
Detection of the divergences – indicator for MetaTrader 4
The indicator displays divergences in the form of two matched lines: one on the price chart, the other — on the indicator chart. It allows to register four classes of divergences. For each of the divergence class there is a switch to indicate the necessity of its registration, as well as the color selection of the bull and the bear divergence lines:
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One of the six standard indicators included in the DivergenceViewer (RSI, MACD, Momentum, RVI, Stochastic, Standard Deviation) is used as an indicator that serves as data source for the lookup of the divergences with the price (in the indicator’s terminology — the base indicator). The indicator can also operate with two non-standard indicators: Derivative and William Blau.
The parameters of the base indicator are set in the input parameter block with the same name:
The parameters should be set in the same order as they are presented in the standard indicator. For example, for the Stochastic base indicator the accordance will be as follows:
- «The first calculation period» — %K,
- «The second calculation period» — %D,
- «The third calculation period» — slowing.
If the number of the base indicator parameters is less than three, then the corresponding calculation periods are simply not displayed, and the values of these parameters are ignored. So, for the RSI and the Momentum indicators it is sufficient to set the values of only two parameters: «The first calculation period» and «Indicator calculation price».
If some other indicator needs to used as the base indicator, then choose the value «Custom» in the «Base indicator» parameter, and fill the following lines in the «Custom indicator» block:
- «Indicator name» — the name of an indicator, which is present in the «Navigator» window of the terminal. Specified without the extension.
- «Index of the buffer for data pickup» — the index of the indicator line, values of which will be used for plotting the base indicator chart (most often — 0).
- «Number of the indicator parameters» — specify the amount of the input parameters used by the indicator. If set to 0, then the default parameter values will be used for the base indicator.
- «Value of the N-th parameter» — set the values of the corresponding parameters of the base indicator.
After setting up the base indicator it is necessary to determine the maximum length of the divergence by filling the «Depth of the 2-nd support point lookup» parameter, and to define how much the price extremums must match the indicator extremums — the «From price extremum to indicator extremum» parameter.
The divergence registration is based on the local extremum lookup. To form any extremum at least three bars are needed, the central of which is the extremum. For that reason, the registration of the divergences is made with a two bar delay. The figure shows the class A divergences and bars marked with vertical lines (not part of the indicator), which show the divergence registration places.
The full description of the indicator capabilities and its formation logic is available in the «Divergences on the current chart» article.
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