How to Find and Trade Divergence with RSI Indicator

You must be wondering what the divergence is. Probably you are guessing or you are the one of the few who knows what that signal is. Divergence is an early sign of market behavior soon. The market usually reaches its maximum at the reversal and makes us aware that it will no longer have the strength required to keep moving in the same direction.

Before reading the article and writing your questions in the comments section, I recommend to watch this video. It’s not long but covers the biggest part of questions on the topic.

The dictionary provides a shortlist of the related words as the interpretation of this term: direction change, deviation, discrepancy and difference.

Trading on the forex market, you will come across a divergence phenomenon, which reveals in the following: “the direction of the indicator’s movement diverges from the direction of the price movement”.

This phenomenon is mostly reflected by the MACD, Stochastic Oscillator and RSI indicators. You can also see the divergence on other indicators that you may never think about.

As you know, the market moves up and down even within a trend. The oscillator strictly follows the price movement. If the market moves upwards, the oscillator also moves upwards. When the market draws a higher maximum, the oscillator also draws a higher maximum.

Divergence is formed when the market shows a high maximum on the chart and the oscillator does not show a higher maximum but draws a lower maximum instead! It happens when the oscillator indicates that the market has weakened and there is a high probability that the price will retrace (pullback) or even the market will reverse shortly.

The market shows a higher maximum but the indicator shows a lower one instead!

The divergence in the example above is the classical “bearish” divergence. I think we should introduce you to the new terms and their meaning one by one. This example is designed to show you that the indicators do not always reflect the trend on the market. Therefore, you can use this discrepancy to open a position!

You can see a similar situation in the falling market. If the market shows the lower minimum, the indicator will also display the lower minimum. If you see that the price chart is discrepant to the indicator, you may assume a possible direction change.

The divergence above is called the classic “bullish” divergence. The term “bullish” refers to the price chart direction, in which the market will move after the divergence.

• The “bullish” divergence in case the price will go upwards.
• The “bearish» divergence in case the price will go downwards.

DIFFERENT KINDS OF THE DIVERGENCE

We have already discussed the possibility of trading within both types of trends using various counter-trend trading techniques. There are different kinds of divergence.

The counter-trend divergence is the most common type of divergence. Many traders know how to trade against the trend to some extent. Since these techniques are widely spread in the common trading, this kind of divergence is called the classic or common divergence. Many other trading systems are based on divergence, though a trader may fail to see its presence. We will do our best to help you understand the trading techniques in this guide. You will be able to determine the divergence in your trading strategies and apply other trading principles.

TYPES OF DIVERGENCE

1. Classic (or common) divergence
2. Hidden divergence
3. Advanced divergence

Classic divergence is the most widely spread one. It occurs when a trend reverses.

Approximately 25% of the traders who use common divergence, also know about the hidden divergence. Hidden divergence is considered a sign that the trend will keep moving.

Advanced divergence is also considered the sign of the trend continuation. However, few people know about this divergence type though it is a strong signal that you can apply in trading.

CLASSIC DIVERGENCE

Common divergence is the divergence type that forebodes the trend reversal on the forex market and can serve as the signal for opening long/short.

• The common bearish divergence is the signal that the price chart is about to go downwards. So be ready to open shortly.
• The common bullish divergence is the signal that the price chart is about to go upwards. So be ready to open long.

CLASSIC BEARISH DIVERGENCE

If you want to identify a common bearish divergence, you should keep an eye on the highs (or peaks) of the price chart and the indicator. Common bearish divergence occurs when the price chart displays a higher maximum and the indicator shows a lower maximum. You don’t need to wait till a series of higher highs on the price chart (on the market). All you need is to see one higher peak compared to the previous one. If the indicator shows a divergence, it is a signal to the possible downward movement, which can be used to open shortly.

CLASSIC BULLISH DIVERGENCE

To identify a common bullish divergence on the Forex market, you should keep an eye on the minimum (or lows) of the price chart and the indicator. Common bullish divergence occurs when the price chart shows a lower minimum and the indicator chart shows a higher minimum. Like I have said before, you don’t need to wait for a series of the lower minimum on the price chart. You just need to see one lower minimum compared to the previous one. If the indicator shows a divergence, then it is a signal to the possible upward movement, which can be used to open long.

COMMON BULLISH DIVERGENCE

As you can see from the examples on divergence, in most cases, you will see a line connecting the first maximum (or minimum) with the second maximum (or minimum) both on the price chart and on the indicator. This is the best way to define divergence. After a while, you will be able to see divergence by eye but the connecting lines will help you a lot at the beginning of your study of this signal. I’ve been using divergence as a signal to enter the market for many years but even now I still draw the auxiliary lines on the charts.

THE HIDDEN DIVERGENCE

The hidden divergence is the signal of the trend continuation and it is much more difficult to see. Few traders know about its existence. Like the common divergence, the hidden divergence can be a signal to open either long or short.

• Hidden bearish divergence is the signal that the price chart keeps going downwards.
• Hidden bullish divergence is the signal that the price chart keeps going upwards.

THE HIDDEN BEARISH DIVERGENCE

To identify a hidden bearish divergence, you should keep an eye on the highs (or peaks) of the price chart and the indicator. A hidden bearish divergence occurs when the price chart (the market) is moving downwards and draws the lower maxima. In this case, the indicator is displaying divergence and draws the higher maxima.

HIDDEN BULLISH DIVERGENCE

To identify the hidden bullish divergence, you should keep an eye at the minima (or lows) of the price chart and the indicator chart. The hidden bullish divergence occurs when the price chart (the market) is moving upwards and draws the higher lows. In this case, the indicator is displaying the divergence and draws a lower minimum.

Sometimes people compare hidden divergence to a slingshot. The thing is that the indicator acts like a slingshot: the market rushes in the same direction it has been moving after a small retracement. The indicator displays a small pullback, giving you a good signal to enter the market.

THE ADVANCED DIVERGENCE

Advanced divergence is very much like the common divergence. However, in this case the price movement chart draws a figure very similar to a double top or double bottom. Along with the fact that the second high (or bottom) on the price chart is at the same level as the first one, the indicator also draws the second maximum (or minimum) at another level, which differs significantly from the first one. This advanced interpretation of the market behavior indicates that the market keeps moving in the same direction.

If the market rises and falls similarly, there is quite often a hope that some consolidation will occur. Advanced divergence may indicate that the market still has sufficient potential to continue its movement and that consolidation won’t happen yet.

Advanced divergence is a variety of the common counter-trend divergence. You can see it each time at the bottom of the strong market movement, at the moment when the market starts to “think” about suspending its movement. Instead of reversing the movement direction and forming a consolidation figure, the market will keep moving in the same direction.

• Advanced bearish divergence is the signal that the price chart keeps going downwards. So be ready to open shortly.
• Advanced bullish divergence is the signal that the price chart keeps going upwards. So be ready to open long.

ADVANCED BEARISH DIVERGENCE

To identify an advanced bearish divergence, you should keep an eye on the highs (or peaks) of the price and the indicator charts. You can identify an advanced bearish divergence by the highs of a large price movement. The market forms a kind of double top but note that the double top does not have to be classic. The second maximum can be slightly higher or lower than the first one. Despite the maximum on the price chart are approximately at the same level, the indicator will show a significantly lower second maximum. The indicator DOES NOT draw a double top similar to the chart. The connection between the price chart and the indicator will seem rather unusual… advanced.

The maximum on the price chart is approximately at the same level and resembles a double top. The indicator displays a significantly lower second maximum.

You can treat this situation from the other side. Steering clear of the advanced divergence, you can see that the price chart draws a double top (or a double bottom) while the indicator does not attempt to form a double top (or a double bottom). It looks like the indicator doesn’t even try to copy the price movement.

ADVANCED BULLISH DIVERGENCE

To identify the advanced bull divergence, you should keep an eye on the minimum (or the lows) of the price and the indicator charts. You can usually determine the advanced bullish divergence by lows of a large movement. The market forms a kind of double bottom but the double bottom does not have to be classic. The second minimum can be slightly higher or lower than the first one. Despite the minimum are approximately at the same level on the price chart, the indicator will show a significantly higher second minimum. The indicator DOES NOT DRAW a double bottom similar to the chart. The connection between the price chart and the indicator will seem rather unusual… advanced.

The minimums are approximately at the same level on the price chart, resembling a double bottom. The indicator shows a significantly higher second minimum.

CONCLUSION

Divergence on the Forex market is a constant phenomenon and the strongest element of technical analysis. However, it is not easy to notice the divergence on the live chart. Your experience is the only thing that may help you to do that.

Naturally, you should not rely solemnly on divergence while opening a position on the Forex market. You should take into account other indicators’ readings, chart patterns, support/resistance levels and the Price Action signals.

Don’t forget about divergence when you use the oscillators next time. That is very important.