What is divergence? In simple terms, divergence is separation. Most of the trading indicators that fall under the oscillator category are divergence indicators. They are the go-to indicators for traders in trend confirmation. The truth is that they can be used for so much more:
- Gauging the momentum in a trend.
- Identifying potential trend reversal points for reversal trading.
- Filter for the perfect trade entry.
To identify divergence on a trading chart, the divergence indicator’s momentum compared to the market price action wanes, followed by the indicator and the market prices moving in opposite directions. On the same note, there is a phenomenon known as the hidden divergence which confirms a continuation of the existing trend. The two divergences need to be distinguished if one is to make profits in the markets.
The advantage of divergence indicators is unlike lagging indicators; focus on future price movements. Thus, divergence indicators give traders a chance to ride the resulting price movements for longer rallies than lagging indicators.
Below is a guide to the best divergence indicators that work in any market.
MOVING AVERAGE CONVERGENCE DIVERGENCE
The moving average convergence divergence, which is a trend-following oscillator, is in short referred to as the MACD. It utilises moving averages as its design building blocks: a fast-moving exponential moving average and a slow-moving exponential moving average. What is plotted on the charts is the difference between the slow and fast-moving exponential moving averages referred to as the MACD line, coupled with a signal line. The signal line is an exponential moving average based on the MACD line. Most traders use a standard period setting of 9 for the signal line. The signal line and MACD lines oscillate around various levels, mostly 0, 20, 50, and 80.
Traders are also fond of customising the MACD to appear positive and negative histograms instead of the line graphs, but the interpretation is the same.
The MACD alone cannot make a robust trading strategy. The perfect role for this trading indicator is as a filter indicator. When paired with another trading indicator, the divergence between the MACD line and the Signal line informs on the best entry points to trade and the best trade exit points. How does it do this?
The divergence between the two lines, the signal and MACD lines, shows the momentum of the prevailing market prices. Therefore, a trade entry with the lines diverging shows that the momentum could lead to a price rally. The inverse is true; an entry with the MACD lines converged indicates a market devoid of momentum and should be avoided. On the other hand, an active trade that exhibits divergence between the MACD direction and the prevailing market direction, moving in the opposite direction, identifies potential price reversal points and should be considered a trade exit point.
At a glance, the awesome oscillator can be confused with the MACD, moving average convergence divergence. However, whereas the MACD identifies reversal points primarily through overbought and oversold price zones, the awesome oscillator indicator gauges change in the market momentum and validate identified trends.
Like all other oscillators, the awesome oscillator indicator, AO, has a 0 level with its histograms generated on either side depending on the market momentum. The divergence of the AO indicates a change in market momentum and a high probability of reversal. The awesome oscillator divergence is useful in:
- Acting as a trade exit parameter.
- Working as an early trade entry trigger.
THE RELATIVE STRENGTH INDEX INDICATOR
This momentum indicator is known to most people by its acronym, the RSI. Relative Strength Index Indicator is similar to the MACD in that it is based on moving averages and identifies possible trend reversal points through price saturation levels. The difference between the Moving Average Convergence Divergence and the RSI is in the levels used and the nature of the moving average in use:
- Where the Moving Average Convergence Divergence use levels 20 and 80 for price saturation, the RSI uses levels 30 and 70.
- Where the MACD utilises exponential moving averages, the RSI uses a simple moving average.
As a result of relying on the simple moving average, the RSI indicator has been known to generate a lot of false signals if used as the sole filter indicator. To overcome this challenge and reduce drawdown associated with false positives, traders tweak with the moving average in use to evolve the simple RSI indicator into the Laguerre relative strength index indicator.
The Laguerre RSI indicator overcomes the simple RSI Achilles heel by utilising gamma coefficient on weighted moving average. By weighing the moving average prices using a gamma coefficient, the Laguerre RSI achieves smoothness in the RSI indicator devoid of market noise.
When the relative strength index indicator exhibits divergence with the prevailing trend, moves in the opposite direction, it indicates reduced market momentum and potential trend reversal. At this point, active trades should be monitored for an exit when the reversal occurs, and counter trades should be set up to take advantage of the reversal.
COMMODITY CHANNEL INDEX INDICATOR
CCI, Commodity Channel Indicator, is a momentum indicator that compares the current market prices to a pre-calculated average price over a specified period. It is a filter indicator common to trend trading: the original application design goal was to spot changes in the long-term trends.
The CCI Indicator fluctuates around a 0 level, oscillating between the negative and positive territories depending on the prevailing market conditions. The market is between -100 and +100 levels, with any market beyond these levels being either extremely weak or extremely strong, respectively.
The Commodity Channel Indicator divergence hints at a loss in market momentum and probability of trend reversal. A bullish CCI divergence occurs when market prices make a new low, yet the indicator is inclined upwards. On the other hand, a bearish divergence occurs when the market prices make a new high, but the CCI indicator is tilted downwards. CCI divergence should be validated to reduce false positives in strongly trending markets: bearish divergence by CCI going negative and bullish divergence by the Commodity Channel Indicator turning positive.
STOCHASTIC OSCILLATOR INDICATOR
The stochastic oscillator is a popular filter indicator, as evidenced by the multitude of trading strategies utilising it. This momentum indicator oscillated between 0 and 100, showing the market price’s relative position in a given timeframe.
The %K period settings show the market price position: use a high period than the active timeframe to smooth out the indicator and reduce false positives. The %D period settings plot a moving average of the %K. It is set depending on the desired level of trading activity, less period for more trading activity, and vice versa. The moving average to use is dependent on the level of responsiveness to the prevailing prices desired.
Stochastic divergence occurs when the market direction moves in the opposite direction to the stochastic oscillator: the market makes higher highs while the indicator makes lower highs, or the market makes lower highs with the indicator making higher highs. The stochastic indicator divergence hints at a possible price reversal calling for close market monitoring.
RULES FOR TRADING DIVERGENCE
When using divergence indicators to trade, there are some cardinal rules to increase the chances of profitability:
- Price Confirmation; prices must form patterns that confirm divergences such as double tops, double bottoms, higher highs, or lower lows.
- Connect tops and bottoms only; use the trend line to connect successive highs or lows to be able to clearly identify divergence between the market prices and the divergence indicator.
- Alignment; the highs and lows identified for divergence trading must be vertically aligned between the price chart and the indicator window for the divergence to be valid.
- Incline; for a divergence to be accurate, the price chart’s angle has to be opposite to the indicator’s angle.
- Timeframe; divergence on the longer timeframes is more reliable than on, the shorter timeframes due to reduced market noise.
These rules are not written down on any manual of the trading indicators discussed above. However, these rules’ application exponentially increases the chances of divergence trade setups ending up as winning trades.
All of the trading indicators above play the role of filter indicator perfectly. Using them as individual trading strategies is ill-advised. These trading indicators are dependent on the active timeframe of trades and the individual trading styles. It is also advisable, where possible, to pair any combination of these trading indicators for divergence trading validation: reduces false positives, relatively improving the winning rate of the trading strategy.
Divergence patterns hint at a trend reversal. In most cases, the reversal is not instantaneous. However, the more visible and persistent the divergence is, the high the probability that the reversal occurs.
Before using any of the divergence indicators discussed, attach them to a chat and back-test the divergence strategy to familiarise with the trade setups. It also gives insight into the reliability of these trading indicators.