Divergence in Forex trading is a common signal used by trader during technical analysis. It is a good indicator of potential trend reversal in market movement.

In this article, we will cover what divergences are and how to use divergence in forex trading.

What is Divergence in Forex Trading?

Divergence in Forex refers to a situation where the price action of a currency pair diverges from a technical indicator. That is, the price of an asset moves in an opposite direction form an indicator such as the stochastic oscillator.

For example, the price maybe making new highs but the oscillator is making new  lows. This discrepancy can signal a potential reversal of the current trend.

Common Indicators Used in Divergence

There are three indicators commonly used to spot out divergence in forex trading. They are:

1. RSI (Relative Strength Index): A momentum oscillator that measures the speed and change of price movements.
2. MACD (Moving Average Convergence Divergence): A trend-following indicator that compares two moving averages.
3. Stochastic Oscillator: Another momentum indicator that measures the closing price of a security relative to its high-low range over a specific period.
4. Another oscillator known as the Chaikin oscillator can also be used.

Types of Divergence

Positive Divergence

In this type, the price of the currency pair is making new lows, but the indicator is making new highs. This usually signals a potential bullish reversal, as the price may be oversold.

Negative Divergence

In the negative variation, the price of the currency pair is making new highs, but the indicator is making new lows. This suggests a potential bearish reversal, as the price may be overbought.

How to Identify Divergences While Trading

The main sign of a divergence is when the price forms a double top or double bottom pattern. Hence, there should be two visible highs or two visible lows on the chart. You can only spot it by looking at the high or low points on the price chart and the indicator. The highs should match up.

In order to spot out a divergence, traders must follow these steps:

1. Choose an indicator: Select a suitable indicator based on your trading style and preferences.
2. Observe price action: Monitor the price action of the currency pair and the corresponding indicator.
3. Identify divergence: Look for instances where the price action and the indicator are moving in opposite directions.
4. Confirm the signal: Consider other factors, such as volume and chart patterns, to confirm the signal.

How to Use Divergence in Forex Trading

There are different types of divergence signals that could be analyzed from charts. It is a basic signal, however, many people find it confusing in Forex trading. This is because there are different kinds of divergences.

They could either be regular or hidden, direct or reverse, and ultimately, they can be bullish or bearish.  Therefore, they could be used to signal a trend reversal or trend continuation, depending on the type.

To trade for either a bullish or bearish reversal, it is important to first confirm the signal. Take your trade entry at the point where the trend line breaks out.

However, when the indicator is rising while the price is falling, it shows extended bearish divergence. This usually means a fake trend reversal will follow.

To decide when to enter a trade, use the MACD moving averages. When they cross below zero, it usually signals a trend reversal. But because of the hidden bearish divergence, it is possible the price will break above zero and then fall back down.

No matter how you trade, you should always use stop-loss and take-profit orders. You can’t watch the market 24/7.

These tools will protect your money and help you lock in profits. If you’re trading based on divergence signals, set a stop-loss above the highest high for a downtrend and below the lowest low for an uptrend

Conclusion

Divergence is a leading indicator, meaning it can signal a potential reversal before it actually occurs. However, it is essential to combine it with other technical analysis tools and consider the broader market context for accurate trading decisions.