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. In the case of a potential top, regular divergence occurs when price is making higher highs, but the indicator is NOT.
A divergence is used by many traders as a leading indicator. What is a leading indicator? It is an indicator that can sometimes forecast a reversal of price trend.
In other words, divergence sometimes has the ability to find bottoms and tops.
The indicator/oscillator is signaling to you that a shift in momentum is taking place and that price may not be able to sustain it's direction much longer.
Therefore, price might be ready to reverse and start a new trend.
Confused? Don't be. This is simple stuff.
The diagram below explains a regular divergence much better than I can in words.
Take a look.
The image above show a bullish divergence. If you see an indicator showing this type of pattern compared to price, it is an indicating a potential bottom. Notice I said "potential". Divergence techniques, like everything else in day trading or any kind of trading for that matter, only works some of the time.
For every divergence pattern that you see successfully leading price out of a bottom or top, you'll see more that have failed. You can, however, increase the chances of divergences spotting profitable trades if you require a
double divergence pattern, rather than just a single divergence as in the image above.
I'll go ahead and show you what I mean with an actual stock chart example.
5 min. or 10 min. Chart
MACD (no histogram)
MACD setting: 3-9-15
DIVERGENCE TRADING STRATEGY
The key point here is that double divergence patterns should give a higher probabilty of winning trades over single divergences, simply because momentum has slowed even more and price could be closer to exhausting its current move.
Do I have any hard evidence to support that statement? Nope. Just plain observation of thousands of charts. In fact, I've rarely used regular divergences to trade off of. Just not my style.
But, it's such a popular method of trading, I felt I should include a page here on it, in case someone would be interested in learning about a divergence trading strategy.
Lets take a look at GE below, trending down between 12:00 to 2:00. Notice how at around 12:30 price makes a lower low, but the MACD makes a higher low. There's your first divergence.
Now look at around 1:45. Price continues to make a lower low, but again the MACD makes a higher low, indicating price momentum has reduced even further. There's your double divergence.
You'll may also notice, had you bought GE during that first divergence, in an attempt to catch that bottom, you would've been stopped out for a loss. And, don't get me wrong.......this is going to happen sometimes with double
divergences as well. Maybe just not as often.
But getting back to the chart, once that second divergence has formed, you can put a trendline on price and and a buy stop above the trendline to catch a possible breakout. If you get an entry, treat it as a regular breakout and place your stop accordingly.
Generally, you're going to see volume start to dry up during the second divergence and then you of course, you want to see volume really pick up during and after the trendline breakout.
You probably noticed I used the term "regular divergence" a few times. You may not know that there's another type of divergence called reverse divergence, sometimes called hidden divergence.
It's a divergence trading strategy that trades with the trend, rather than against it, like the above.
You also might like to see some examples of reverse divergences using the RSI Indicator.