Trading Strategy: How to trade divergence with technical indicators

Using the divergence of a technical indicator from the movement in a market price is a day trading technique especially popular with forex traders. This technique is based on the principles of bullish and bearish divergence, which are key indicators that traders use to predict potential market reversals. Divergence can be spotted on trading charts when the price of an asset and an indicator, such as the moving average convergence divergence (MACD), are moving in opposite directions. This is a signal that the current trend may be weakening.

However, spotting divergence is not enough—it's crucial to understand how to employ effective strategies when trading divergence. This might involve the use of stop-loss orders, the analysis of support and resistance levels, and the careful monitoring of the asset's momentum. Even with these strategies in place, risk management remains a fundamental aspect of trading divergence. It's crucial to manage your investment size and to have a clear exit strategy before entering a trade.

Lastly, we will look at some real-life case studies and examples of successful divergence trading, to provide practical insights into this technique.

Contents: HowTo Divergence Trading


What is divergence in trading?

Divergence is a method used in technical analysis when the direction of a technical indicator, usually some form of oscillator ‘diverges’ from the overall price trend. In other words, the indicator starts moving in the opposite direction to the price and the trading oscillator signals a possible trend reversal.


Bullish divergence is when the price is moving lower but the indicator turns and points up

momentum bullish divergence


Bearish divergence is when the price is moving higher but the indicator points down

momentum bearish divergence


NOTE: it is what the technical indicator is doing that dictates whether the signal is considered bullish or bearish.


Understanding bullish and bearish divergence

Divergence in trading refers to the disagreement between the price action and the oscillating indicator. It's a valuable tool for identifying potential market reversals. There are two types: bullish and bearish divergence.

Bullish divergence is when the price of an asset is making lower lows, while the indicator (such as RSI or MACD) is making higher lows. This suggests a potential upward reversal. 

Bearish divergence on the other hand, occurs when the price is making higher highs, but the indicator is making lower highs. This can indicate a potential downward reversal.


How does divergence in trading work?

The change in direction of the indicator is taken by day traders to mean that price might be about to follow. The oscillator in this scenario is used as a leading indicator for the price.

The logic behind divergence to analyse the market price is that the indicator is showing a slowdown in momentum of the price. The momentum of the price will often change before the price itself.

Think of it like if you throw a frisbee into a strong wind - the frisbee will go against the wind for some time, then it will slow down and lastly it changes direction and flies with the wind.

Which indicator is best for divergence?

There is no one single most popular indicator for trading divergence. Every technical indicator has its own benefits and pitfalls. We will cover the three most popular indicators: RSI, MACD and Stochastic.

Trading Strategy: RSI for trading divergence

The RSI indicator is a momentum indicator plotted as an oscillator between 0 and 100 under the candlestick chart, known as an underlay indicator. The RSI is calculated by averaging the price gains and losses over the previous 14 periods. It was created by J. Welles Wilder Jr in his book “New Concepts in Technical Trading systems.”

RSI indicator divergence

The indicator creates a smooth line that tends to track the trend in the price and lends itself well to divergence trading. When set to the default 14-period setting, the RSI indicator gives few overbought and oversold readings. That means that when it comes to using divergence as a trading signal, there tend to be less signals but they are more reliable when they occur.

Trading Strategy: MACD for divergence trading

The MACD is a momentum indicator that is best used in trend-following environments. The trend indicator plots a signal line as well as a histogram that shows the difference between two moving averages. The moving averages will converge and diverge as the trend progresses and eventually reverses.


MACD indicator divergence

The visual of the histogram lends itself well to trading divergence but it is less open to interpretation when a new ‘swing point’ has been made. There is no pre-defined area of overbought and oversold in the MACD so deciding which trend trade signals are reliable enough to use is more difficult. This can be overcome by using previous peaks on the MACD as using them effectively as areas of support and resistance. Because it is best used in trending environments, the MACD will produce many false signals counter trend.

Stochastic for trading divergence

Stochastic is a momentum technical indicator that works by comparing the last closing price with a range of previous prices over the last 14 periods.

stochastic indicator divergence

The stochastic is a more sensitive indicator, meaning it will offer more divergence signals and thus more trading opportunities but that also means more false signals.


Is trading divergence profitable?

Yes, but not all the time! We have to remember that indicators filter price action. That filter can help us focus on what is important or miss what's important, depending on the trade setup.

The major advantage of using divergence as a trading signal for how to time a trade entry is that it gives the signal before the price trend has changed. This early signal gives the trader a better entry price for their trade.

The disadvantage of using divergence as part of a good trading system is that it can give ‘false signals’. As the name suggests, this is when the indicator changes direction but the price trend does not reverse as the indicator suggested. This will quite often happen when the indicator gets very overbought or oversold. The momentum of the trend will weaken but the trend remains in tact.

How do you confirm divergence?

There are some tried and tested techniques to reduce the number of false signal and optimise the number of profitable trades.

  • Only take divergence signals in the direction of the long term trend. Or alternatively in a rangebound sideways market. For example in a bear market, only take bearish RSI signals and in a bull market only take signals to buy from the RSI.
  • Always wait for the candle that is confirming the divergence to close. Indicators will give a signal according to the current state of the candle. If the candle closes differently, a trading signal from divergence can disappear as quickly as it appeared.
  • Use other indicators to confirm the signal such as support and resistance levels, round numbers, pivot points or a price action trading pattern.


How to Spot Divergence on Trading Charts

Spotting divergence on trading charts requires a keen eye, but with practice, it can become second nature. Here are some steps to identify divergence:

  • Identify the trend: The first step is to determine whether the market is in an uptrend or downtrend.
  • Observe the price action: Look for higher highs or lower lows in the price.
  • Compare with the indicator: Check if the indicator is confirming the price action. If it's not, you may have spotted a divergence.
    Remember, divergence doesn't always lead to a reversal, but it can signal that the trend is weakening.

Setting up your trading platform for divergence

From your FlowBank trading application you can right click on your chart and select indicators.


Flowbank trading platform technical indicators

Then from the list of indicators, you can choose RSI, MACD or any of the popular indicators previously discussed. Then the indicator will appear on the chart and you can adjust the settings of the indicator. To remove the indicator you click the arrow to move it from ‘Active’ to ‘All’.


Flowbank trading platform technical indicators



Strategies to Use When Trading Divergence

Trading divergence can be a powerful strategy if used correctly. Here are some strategies you can use:

  • Trend reversal strategy: This is the most common strategy. When you spot a divergence, prepare for a possible trend reversal and plan your trades accordingly.
  • Continuation strategy: Sometimes, even after a divergence, the price continues in the same direction. Traders can use this as an opportunity to add to their existing position or to start a new one.
  • Confluence strategy: This strategy involves looking for other signals or patterns that confirm the divergence, providing a stronger signal.


Risk Management in Divergence Trading

As with any trading strategy, risk management is crucial when trading divergence. Here are some tips:

  • Set stop-loss orders: This can limit your potential loss if the price moves against your prediction.
  • Don't risk more than you can afford to lose: Never put all your capital into one trade.
  • Use proper leverage: Leverage can amplify profits, but it can also amplify losses. Use it wisely.


Case Studies and Examples of Successful Divergence Trading

Studying real-life examples can help traders understand how to effectively use divergence in their trading strategy. Here we will take a look at some successful cases of divergence trading.


Should I trade using divergence?

In summary, trading divergence can be an effective addition to your trading strategy, especially if already using indicators like RSI or MACD to find overbought and oversold levels but should not be replied on by itself and requires practice to get it right.

Good luck trading!

Related articles

What is a Trend Line? | Top Trendline Trading Strategies

What is a Trend Line? | Top Trendline Trading Strategies

Candlestick charts are graphical way of representing the open, close, high and low of the price of a market over a given period of time developed in Japan.

Candlestick Reversal Patterns | Top 5 for Forex Trading

Momentum Strategies For Going Short Index CFDs

3 Momentum Trading Strategies For Going Short Index CFDs

Day Trading Strategies For September

Day Trading Strategies For September