Divergence indicates to traders that the current price trend is moving contrary to what their technical indicators are predicting. Identifying what divergence is important because it helps traders determine when it is the appropriate time to exit a position.
Paying attention to divergence and convergence is especially important when using a momentum trading strategy. In theory, positive momentum indicators could predict that the value of an asset will increase perpetually. But in the real world, eventually, price trends will begin to reverse—finding instances of divergence can help you identify possible reversals and make appropriate decisions.
Momentum trading strategies are very common in the world of foreign exchange (forex) trading. Because many currencies will fluctuate in relative value throughout the day, their short-term trends will unfold very quickly. If you wait until the end of the week to change your positions, you will miss out on numerous trading opportunities.
In this article, we will discuss the most important things to know about using divergence and convergence when developing a forex trading strategy. Though divergence is just one of many key indicators for you to pay attention to, it is certainly among the most important.
What is divergence? What is convergence?
As suggested, divergence trading is a term used to describe an instance when the price of the underlying asset (such as a currency) is moving in a direction opposite to what the technical indicators may have predicted. For example, positive changes in the simple moving average (SMA) may suggest to traders that prices are about to increase in value. But if prices begin to decrease in value—contrary to the indicator—an instance of divergence will have occurred.
As you might guess, convergence is a term used to describe instances where technical indicators and price movements align. When convergence occurs, this not only suggests that the technical indicator has strong predictive value—it also suggests that the underlying trend may be gaining strength. When convergence is strong, the risk of entering into a trend-positive position (going long when prices are increasing) will be dramatically reduced.
What does divergence indicate to traders?
Divergence indicates to traders that the already existing trend is getting weaker and may eventually reverse. Contrary to what you might assume, divergence does not necessarily indicate that there is something “wrong” with whatever technical indicators you are using. Rather, divergence merely suggests that prices are changing and that the market has become more unpredictable.
In the forex market, and all other speculative markets, divergence is highly correlated with increased levels of volatility. Often times, divergence will occur when a price is undergoing a fundamental transformation. For risk-averse traders, divergence is an indicator it may be a good time to exit their positions. For risk-tolerant profit-seekers, however, divergence likely indicates that multiple opportunities are about to emerge.
Why is divergence especially useful for momentum traders?
No matter what trading strategy you might prefer to use, divergence is something you should always pay attention to. At the very least, instances of divergence ought to suggest that there is something going on that needs to be investigated.
Divergence is especially relevant for momentum trading strategies. Momentum traders are not just concerned about the direction of the price trend, they are also deeply concerned about its relative strength. Even if a price is still increasing in value, if it begins increasing at a notably lower rate, it may be time to exit a given position.
Momentum trading indicators can help you identify price reversals before they actually occur. In this sense, paying attention to divergence is a proactive—rather than reactive—approach to the trading world.
What are the best momentum trading indicators?
Momentum represents the rate that an asset’s price or trading volume is changing. Naturally, if prices are increasing at a relatively high rate, the risk of entering into a position (when all else is equal) will be lowered. There are many different indicators you can use in order to identify momentum:
- Moving Average Convergence Divergence (MACD): the MACD follows two separate moving averages and closely monitors their relationship. Usually, these averages take place over a 12 or 26 day period. When one line crosses over the other, this is a form of divergence suggesting a trend reversal may occur.
- Money Flow: the money flow is a volume indicator that averages the high, low, and closing prices, then multiplies by the daily trading volume. The money flow is a comprehensive indicator that makes it easier to infer momentum.
- Relative Strength Index (RSI): the RSI makes it easy to determine whether the underlying asset is overbought or oversold. On a scale of 0 to 100, readings under 30 suggest its oversold while readings over 70 suggest that its oversold.
- Stochastic Oscillator: the stochastic oscillator is a momentum indicator that compares the recent closing prices of an asset to its historic closing prices. When the price has “broken out” of the oscillator’s range, this is an instance of divergence that indicates a price reversal is likely to occur.
The best trading strategies will likely include multiple technical indicators. Using multiple indicators will make it easier to test the legitimacy of instances of divergence.
How can I develop an effective forex trading strategy?
By using the technical indicators mentioned above (among others), you can develop a successful forex trading strategy. But, additionally, paying attention to fundamental indicators will be very important as well.
Key events such as new trade deals, announcements from central banks, global politics, and changing oil prices can all immediately impact the price of a global currency. As soon as these events unfold, markets will begin to react. Because the market’s reaction is often faster than lagging technical indicators, these stories can often cause instances of divergence to occur.
Divergence is something you should always keep an eye out for. However, if you hope your strategy to be truly effective, you should try to identify why divergence is actually occurring. By paying attention to both the qualitative and quantitative forces driving the market, you can become an effective forex trader. Additionally, diversifying and investing in multiple different currencies can help reduce the risk attached to each of your positions.
Divergence is an important event that can affect the validity of all forex trading strategies. By identifying when—and why—price movements contradict the predictions made by technical indicators, you can remain ahead of the market and exit your positions with a profit