Is there a low-risk trading method that allows us to sell near the top of the trend and buy near the bottom of the trend? If you already have a long position in a currency, what is the best exit point? If you believe that a certain currency will continue to fall, can you have a way to enter the short position at a better price or with less risk?
There is indeed a way, and that is divergence trading. Simply put, by comparing the price action and the indicator movement trend, we can determine whether a divergence has occurred. It doesn't really matter what indicator you use, you can use RSI, MACD, Stochastic, CCI, etc. More importantly, you can use divergences as leading indicators, and after a period of practice, divergences are not difficult to draw. By diverging from your trading method, you can achieve consistent profits. The great thing about divergence trading is that you can often buy at the bottom of the trend, or sell at the top of the trend. This makes your trade risk much lower relative to your potential gain.
Two types of divergence
A divergence is a divergence between the price and the indicator. Prices are making new highs and indicators are falling, or prices are falling and indicators are rising. Technically, a divergence indicates that a trend reversal is imminent. is a warning sign that you should pay attention to.
Regular divergence:
Regular divergences are used by traders as signals of trend reversals. If prices are making lower lows (LL), but oscillators are making higher lows (HL), then this is a common bullish divergence we see. Regular bullish divergences usually occur at the end of a downtrend. After the second bottom is formed, if the oscillators fail to form new lows, the price is likely to rise, and price and momentum are usually expected to follow in line.
Hide divergence:
Not only can divergences signal a potential trend reversal, they can also be used as a signal of trend continuation. We need to always remember that the trend is your friend, so whenever we catch a signal that the trend is going to continue, it is great news for us. A hidden divergence occurs when price makes a higher low (HL) but oscillators make a lower low (LL). This situation can be seen in the upward trend of the exchange rate. Once the exchange rate forms a higher low, we need to determine whether the oscillator is also showing the same trend. If this is not the case and a lower low is formed, then we can basically confirm the formation of a hidden divergence pattern.
RSI divergence
Before talking about the strategy in detail, let us first understand/review the definition of RSI. Relative Strength Index (RSI) is a technical curve made based on the ratio of the sum of rising points and rising and falling points in a certain period of time. It can reflect the prosperity of the market in a certain period of time. It was first applied to futures trading by Welles Wilder. Later, people found that in many chart technical analysis, the theory and practice of strength indicators are extremely suitable for short-term investment in stocks and foreign exchange markets, so they were used In the measurement and analysis of its rise and fall. The design of this analysis indicator is to use three lines to reflect the strength of the price trend. This graph can provide investors with an operational basis and is very suitable for short-term price difference operations (source: Baidu Encyclopedia). The theory of strength and weakness indicators believes that any big rise or fall in the market price will fluctuate between 0-100. According to the normal distribution, it is believed that the RSI value mostly fluctuates between 30-70, and usually 80 or even 90 is considered to be the market has reached In the overbought state, the market price will naturally fall back and adjust. When the price drops below 30, it is considered to be oversold, and the market price will rebound.
In a trend, use the RSI to gain a sense of the strength of the trend. Here are three scenarios:
The RSI is making higher highs in a strong uptrend, implying that there were more and stronger bullish candlesticks in the latest trend swing than in previous swings.
If RSI makes similar highs in an uptrend, it means that the current trend will not change. The high point at the same height is not a divergence, but only shows that the trend is still rising steadily.
If the price is making higher highs in an uptrend, but the RSI is making lower highs, it means that the most recent bullish candle is not as strong as it was before and the trend is weakening. At this time, it is a deviation.
Why are RSI divergences useful?
Before continuing, I want to talk about why this is important. You might be thinking, "Okay, got it, an RSI divergence occurs when the price goes one way and the RSI indicator goes the other. But what's the use of that?"
Note that the RSI indicator is a momentum or strength indicator. As long as the price and RSI indicators are aligned, we can say that the current trend or price action is showing momentum in a particular direction. But once we see a divergence between the price and the RSI indicator, the momentum will weaken. Divergence in RSI shows that the current trend is losing strength!
If you recall how the RSI indicator is calculated, you will find that as the RSI diverges, the ratio of average gain to average loss begins to change. In other words: RSI divergence shows us that the current trend is losing momentum and conditions for a trend reversal are forming. These are the early stages of a momentum shift, and this is exactly the trade signal we as reversal traders look for!
How to Trade Divergences - Best Entry
Divergences don't always point to price reversals, and sometimes the market just goes into consolidation after a divergence. Remember, a divergence is only a signal that the trend is weakening, its function is not to tell you that the trend will definitely reverse.
I strongly recommend adding an additional layer of protection when trading divergences, such as superimposing another signal. A single divergence signal is not strong, and many traders who only trade divergence signals are prone to encounter bad results. For example, in the picture below, even though there were two divergences, the price still did not fall. After these two divergences, the price only entered a short-term consolidation:
Therefore, like any other trading strategy, instead of trading divergences in isolation, it is better to add other signal convergence to confirm good trade timing.
Tips on Entry Points
Trading entry points are very important, this should be our general understanding. No matter what trading system you use, you need to filter out the really favorable signals by where the signals appear.
Instead of trading a single divergence signal, always keep an eye out for key price levels, which are key support and resistance levels.
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