How to Trade Classic Bullish Divergence and Bearish Divergence
In Forex trading, classic divergence is used as a possible sign for a Forex trend reversal and is used by traders when looking for an area where price could reverse and start going in the opposite direction. For this reason this setup is used as a low risk entry method and also as an accurate way of exit out of a currency trade.
This trading strategy is a low risk method to sell near the top or buy near the bottom, this makes the risk on your trades are very small relative to the potential reward. However, this is one method with very many whipsaws and most traders do not recommend using it.
Divergence in Trading is also used to predict the optimum point at which to exit a trade. If you already have an open trade that is already profitable, a good way to spot a profit taking level would be the point where you spot this setup.
There are two types, based on the direction of the Forex trend:
- Classic Bullish divergence
- Classic Bearish divergence
Classic Bullish Divergence
Classic bullish divergence setup occurs when price is making lower lows (LL), but the oscillator is making higher lows (HL). The example below shows a picture of this setup.
Classic Bullish Divergence
This example uses MACD indicator as a Forex divergence indicator.
From the above example the price made a lower low(LL) but the indicator made a higher low(HL), this shows there is a divergence between the price and the indicator. This signal warns of a possible trend reversal.
Classic bullish diverging signal warns of a possible change in the Forex trend from down to up. This is because even though the price went lower the volume of sellers that pushed the price lower was less as illustrated by the MACD technical indicator. This indicates underlying weakness of the downward Forex trend.
Classic bearish divergence
Classic bearish divergence setup occurs when price is making a higher high (HH), but the oscillator is lower high (LH). The image below shows an example of the setup.
Classic Bearish Divergence
This example also uses MACD indicator
From the above example the price made a higher high(HH) but the indicator made a Lower High(LH), this shows there is a divergence between the price and the indicator. This signal warns of a possible trend reversal.
Classic bearish diverging signal warns of a possible change in the Forex trend from up to down. This is because even though the price went higher the volume of buyers that pushed the price higher was less as illustrated by the MACD indicator. This indicates underlying weakness of the upward Forex trend.
In the above examples, if you had used divergence to trade you would have gotten good trading signals to enter or exit the trades at an optimal point. However, divergence trading signals just like other trading indicators, is also prone to whipsaws. that is why its always good to confirm the diverging trading signals with other technical indicators such as the RSI, Moving Averages and Stochastic Oscillator.
A good MetaTrader 4 indicator to combine classic diverging setups is the stochastic oscillator and wait for the stochastic lines to move in the direction of the divergence signal so as to confirm the trading signal.
Another good indicator to combine with is the moving average indicator, in this indicator a trader should use the Moving Average Crossover System
Example of Moving Average Crossover Method Strategy
Once the divergence signal is given, a trader will then wait for the Moving average crossover system to give a trading signal in the same direction, if there is a classic bullish setup, a trader will wait for the moving average system to give an upward crossover signal, while for a bearish classic divergence signal the trader should wait for the Moving average crossover system to give a downward bearish crossover trading signal.
By combining the classic divergence trading signals with other technical indicators this way, a currency trader will be able to avoid whipsaws when it comes to trading the classic diverging signals, because the trader will wait until the market has actually reversed and is already moving towards this direction, hence the trader will not fall into the trap of picking market tops and bottoms.