Forex indicators
Forex trading can certainly be profitable for a forex trader, although statistics show that more than 70% of traders are either not successful or eventually quit.
The answer to the million-dollar question: Why are many forex traders extremely successful while others fail? is not a clear-cut one. There can be various reasons, like overeagerness, lacking in knowledge of the principles of forex trading, or impatience. However, part of the answer is that profit-making traders successfully use forex indicators.
Forex indicators are simply tools used in technical analysis to forecast price changes of currencies.
There is a wide variety of forex indicators available, including Moving Average (MA), Bollinger bands, Moving Average Convergence/Divergence (MACD) and Divergence.
Divergence, one of the key indicators in the technical analysis of currency trends, will be the focus of this article.
What is divergence in forex trading?
Divergence is when the price movement of a currency is in the opposite direction of the movement of a technical indicator. It is a warning sign that the current price trend may be weakening, and in some cases may lead to a change in the direction of the price.
It is generally assumed that currency prices and forex indicators will move in the same direction if the rates are equal. For instance, if the price is moving to a higher high, then the indicator supposedly follows suit. If the price reaches a lower high, then, presumably, the indicator will move in the same direction. The same principle can be applied to higher lows and lower lows.
If the price and the related indicators do not correspond, then it can be assumed that a change of sorts is about to happen. In a nutshell, a divergence is calculated between highs and lows of price and the related indicators.
Although the divergence strategy is not often utilized, it can be significantly profitable if used with caution.
Even though divergences are used as important trading signals, it does not mean that they will always signal trend reversals accurately and timely.
Additionally, a divergence can be present for a long period without the occurrence of a price reversal.
Types of divergence
The differentiation between the types of divergence is based on the following principle: When the change of the forex indicator is more positive than the change of the price, it is an indication of a bullish divergence. Vice versa, it signals a bearish divergence.
Applying the differentiation above, there are four basic types of divergence.
- Regular Bullish.
- Regular Bearish.
- Hidden Bullish.
- Hidden Bearish.
Some forex brokers refer to the first two types of divergence as class “A” divergence, which is regarded as the most important divergence, able to give the best quality signals. Usually, it is a strong indication of an upcoming price reversal.
The reason why some divergences are called “hidden”, is that they are hiding inside a current trend.
Generally speaking, regular divergences are possible signs for trend reversals, while hidden divergences signal trend continuation.
Regular Bullish
A regular bullish divergence occurs when the price makes lower lows on a chart, while the indicator is showing higher lows.
This divergence pattern indicates that the price is expected to counteract its downward move and to change to a swift upward movement.
Some forex traders prefer to call this type of divergence a positive divergence.
Regular Bearish
Also called by some a negative divergence.
If a new high of a price is above the previous high, while the new high of the indicator is below the previous high, it is called a regular bearish divergence.
A regular bearish divergence is a signal that the price is expected to cancel its upward trend and to switch to a downward trajectory.
Hidden bullish
A hidden bullish divergence is when the price has higher bottoms on a chart, while the indicator displays lower bottoms. It occurs during a price uptrend that should continue upwards.
At times also referred to as positive reverse divergence.
Hidden bearish
A hidden bearish divergence is confirmed when the price is showing lower tops, while the indicator indicates higher tops. It occurs during a downtrend and should continue to the downside.
Can also be called negative reverse divergence.
Difference between a regular and hidden divergence
A regular divergence indicates a reversal of trending price action, while a hidden divergence signals that the price will continue to move in its current direction, either upward or downward.
Tips on how to trade divergences in forex
A trader can use any forex indicator to detect divergences, like MACD (moving average convergence/divergence), RSI (relative strength index), and the stochastic oscillator – a momentum indicator that is widely used in forex trading to identify potential trend reversals.
A big positive of divergences is that you can use them as a leading indicator and will become easier to use after some practice. As a leading signal, it implies that the specific divergence is likely to occur before the actual move. This enable a trader to anticipate a trade and engage in it right at the start of the new emerging move. Thus, enabling you to buy near the bottom of a price trend or sell near the top, making the risk on your trades significantly small in relation to your potential rewards.
Divergences traded with caution and properly, can help to make you a profitable forex trader.
Regarding regular divergences: They are best used when you are trying to choose tops and bottoms. Pay attention for a section where a price will stop and reverse. The indicator utilized, signals that momentum is starting to change and that the price level will not be sustained, even though the price has moved to a higher high or lower low.
With regard to hidden divergences, be aware that they can signal ahead of time a possible trend continuation.
Keep in mind that during periods of consolidation or low liquidity, small divergences between price and forex indicators might form, but that does not imply that you should consider them real divergences.
Frequently Asked Questions
What are the different types of divergences in forex trading?
The types of divergences in forex trading that traders should be aware of are: Regular Bullish divergence, Regular Bearish divergence, Hidden Bullish (or continuation) divergence and Hidden Bearish (or continuation) divergence.
When does Regular Bullish divergence in forex trading occur?
Regular Bullish usually occurs at the end of a Downtrend in the market when the price is making lower lows (LL) while the oscillator is making higher lows (HL).
When does Regular Bearish divergence occur in forex trading occur?
Regular Bearish divergence usually occurs in an Uptrend in the market when the price is making a higher high (HH) while the oscillator is making lower highs (LH).
What does Regular Divergences in forex trading indicate?
Regular Divergences can be a sign of trend reversals.
What does Hidden divergences in forex trading indicate?
Hidden divergence can be a sign of trend continuation.
