The Keys to Developing a Successful Divergence Trading Strategy

Posted by Ariyan Usman on March 9th, 2019

In order to become a successful foreign exchange (forex) trader, you will need to become familiar with a process known as technical analysis. Technical analysis involves looking at various technical indicators, conducting quantitative analysis, and determining whether you should open or close a position in response.

Technical indicators send three different message to forex traders. They may “trigger” a certain action after crossing over a line, they may cross over a centerline (such as the line separating positive from negative gains), and they may signal an instance of divergence.

When utilized correctly, divergence trading strategies are among the most profitable. Most traders prefer trend line trading strategies, which results in “trending” markets to become saturated rather quickly. In this article, we will discuss the most important things to keep in mind when developing a successful divergence trading strategy. By expanding your range of available options as a forex trader, you will find more opportunities on a daily basis.

There are countless technical indicators available for you to choose from. However—at least in the world of forex trading—these are among the most common:

• Moving Average Convergence Divergence (MACD): this indicator shows the relationship between a currency’s moving average over the last 12 and over the last 26 periods. When the 12 periods moving average has overcome the 26-period moving average (or vice versa), this generally indicates that the trend has been reversed.
• Price Rate of Change (ROC): the rate of change helps traders compare current prices to prices in the past. This is one of the easier to use and more accessible technical indicators; it is often used in divergence trading strategies due to the fact that ROC tends to lag behind in a way that creates many divergence opportunities.
• Relative Strength Index (RSI): the RSI, like many indicators, is used to help determine whether an asset has been overbought or oversold. This measures the general “extremeness” of a trend, measured on a scale of 0 to 100. Both divergence and traditional traders will look for RSIs below 25 or above 75. They will tend to avoid RSIs that are in the 25-75 range, due to the fact they are too “noisy”.

Suppose that a price is moving in one direction and a technical indicator is moving in another. Does this mean that the technical indicator has become useless? While your instincts might tell you “yes”, divergence traders will alert you that a lucrative trading opportunity may have just emerged.

Bullish versus Bearish Divergence Strategies

Divergence trading strategies can be used whenever the underlying asset—in this case, a specific currency—has been contradicted by a corresponding indicator. This means that whether the indicator is more positive than the price or the price is more positive than the indicator, there will be many opportunities emerging on a daily basis.

Bullish divergence opportunities occur when the technical indicator is moving in a positive direction and the price has been moving in a negative direction. When this seems to be the case, you may want to consider immediately investing in the underlying asset. This is because—when all else is equal—the technical indicator trend will likely “overpower” the trend of the underlying currency. As a result, both trend lines can be expected to (eventually) begin moving in a positive direction.

Bearish divergence opportunities, on the other hand, occur when the technical indicator is experiencing a negative trend, contradicting the positive trend of the underlying asset. Again, this is due to the fact that the technical indicator is generally “stronger” than the actual price movement itself (though price action traders might disagree). During bearish divergence conditions, it may be time to exit your current position (locking in your earnings) or assume a short position with the underlying asset. Either way, value decreases will be looming on the horizon.

Confirming the Existence of a Price Trend Reversal

In order to become a successful divergence trader, you will need to begin to recognize when a price trend reversal has actually occurred. If you are day trading and opening multiple positions every hour, the bar for what constitutes a “reversal” will be significantly lower. Position traders, who traditionally hold their positions for multiple trading periods, will likely want to be more hesitant before making any firm commitments.

There are quite a few ways for you to test the existence of a trend reversal. You should begin by looking at the general extremeness of the divergence itself. The greater the difference between the technical indicator and the price trend, the more likely that the price trend will eventually conform to the technical indicator. You should also consider using multiple technical indicators at once in order to reduce the risk of trading in response to outliers.

Protecting Yourself from Risk and Maximizing Returns

As you will discover with all types of trading strategies, divergence trading will require you to carefully balance the avoidance of risk and the pursuit of returns. Divergence trading is better for risk-tolerant traders who are willing to take some occasional loses in exchange for higher rates of return.

In order to maximize your effectiveness as a divergence trader, consider any of the following strategies:

• Separate instances of divergence by strength (Class A, Class B, and Class C)
•     Tighten your stop loss or stop limit orders in response to divergence
• Issue a covered call (given you the right to sell at a specific price in the future)
• Diversify the currency pairs you are trading
• Utilize both long and short positions
• Purchase advanced trading software to better identify diverging trends

In addition to all of the tips mentioned above, it will also be crucial for you to get plenty of practice. Using a trading simulator—rather than blindly committing capital—can help you hone your skills as a divergence trader without risking any wealth.

Conclusion

Divergence trading can be very complicated and risky, but it can also lead to some incredible returns over time. In order to successfully develop a divergence trading strategy, you will need to familiarize yourself with the relationship between price trends and forex technical indicators. By keeping these keys to divergence trading in mind, you can begin to exploit these unique market opportunities.