In day trading, divergence is a trading concept that forms on your trading bar chart and results from the price action of a security moving in opposite directions.
This happens when the price of an asset or index makes a higher high but the indicator used makes a lower high, usually the MACD indicator. What this means is that if your indicator and price action are out of sync, then it’s a sign that something is happening on your bar chart.
Day traders are known to make decisions pertaining to situations surrounding divergence. Since it can either be positive or negative, any direction signifies a major shift towards the price.
What you need to know is that positive (bullish) divergence happens only when the securities price shifts lower while the indicator starts to rise. This indicates a weakness in the downtrend.
As a result, it helps day traders to identify and react to the changes brought about by price action. Traders may make one of the following decisions:
i. Tighten the stop loss
ii. Take profits because the situations improves profitability as a result of alerting the traders to protect their profits
How to trade with divergence – Rules you need to keep in mind
1. Price scenarios
As a day trader, one thing you ought to know is that for divergence to exist, price must have formed into one of the following situations: Lower low than previous low, Higher high than previous high, Double top or Double bottom.
If none of the following indicators have occurred, then your situation cannot be described as divergence.
2. Set your eye on the price
It is a common practice when identifying divergence to connect the top to the bottom with a trend line. When it comes to analysis, you have to look at your indicator and make a comparison to the price action.
Regardless of the indicator being used, it is important to keep in mind that you are comparing it to the top and bottom. Common indicators used include MACD, volume or Stochastic.
3. Slopes must differ
When you draw a trend line between the tops and bottoms, you will have a slope. For divergence to exist, the slope of the line that connects your indicator tops or bottoms must be different from the slope of the trend line connecting the price tops or bottoms.
This means that the slope must either be ascending or descending.
4. Never chase it
Experienced day traders are known to check on oscillators like RSI, CCI and Stochastics. Since trends consist of a series of price swings, price momentum plays a vital role when it comes to assessing the strength of the trend.
As such, it is important to know when a trend is forming. It is also vital to keep in mind that less momentum may not result in a reversal but it may signal shift. As a trader, if you miss the opportunity, don’t chase the move. Wait for another swing and start your search.
5. Be careful
Experience has shown that divergence signals are more accurate when it comes to longer time frames. This results in fewer trades. One thing you ought to know is that a well structured strategy will increase your chances of profitability. Shorter time frames do happen and as a result they occur frequently but they are not reliable.
If you want to trade successfully with divergence, look for it on 1 hour charts or longer. While there are day traders who use 15 minute chart, this type of time frame generates too much noise and would result in wastage. Stay away from it!
In trading, the best way to capitalize on divergence is to identify the shift immediately it happens. The only way to do so is by using a trend line which can be drawn between your indicator’s tops or bottoms and the price tops or bottoms. Studying the slope and coming up with the correct strategy for price action will assure you success.