How Do I Trade Classic Bullish Divergence & Bearish Divergence - Classic Bullish vs Classic Bearish Divergence
In FX trading, classic divergence is used as a possible sign for a trend reversal and is used by traders when looking for an area where price could reverse and begin going in the opposite market 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 strategy is a low risk technique 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 technique with very many whipsaws & most traders do not recommend using it.
Divergence in Trading is also used to predict the optimum point at which to exit a trade position. 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 market trend:
- Classic Bullish divergence
- Classic Bearish divergence
Classic Bullish Divergence
Classic bullish divergence occurs when price is forming lower lows (LL), but the oscillator trading is making higher lows (HL). The example below shows picture of this setup.
Classic Bullish Trade Divergence Setup
This example uses MACD indicator as a divergence technical indicator.
From the above example the market price made a lower low(LL) but trading indicator made a higher low(HL), this portrays there is a divergence between the price & the technical indicator. The signal warns of a possible trend reversal.
Classic bullish divergence signal warns of a possible change in the trend from down to up. This is because even though the market price went lower the volume of the sellers who pushed the price lower was less as illustrated by MACD indicator. This indicates underlying weakness of the downward trend.
Classic bearish Divergence
Classic bearish divergence setup occurs when the price is making a higher high (HH), but the oscillator technical indicator is lower high (LH). The screen shot below shows an example of the setup.
Classic Bearish Divergence
This example also uses MACD indicator
From the above example the market price made a higher high(HH) but the technical indicator made a Lower High(LH), this portrays there is a divergence between the market price & the technical indicator. The signal warns of a possible trend reversal.
Classic bearish divergence signal warns of a possible change in trend from up to down. This is because even though the market price went higher the volume of the buyers who pushed the price higher was less as illustrated by the MACD. This indicates under-lying weakness of the upwards trend.
In the example above, if you had used divergence to trade you would have gotten good signals to enter or exit the trade transactions at an optimal point. However, divergence signals just like other trading indicators, is also prone to fake outs. That is why it's always good to confirm the divergence signals with other indicators such as RSI, Moving Averages and Stochastic Oscillator Technical.
A good indicator to combine classic divergence 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 signal.
Another good indicator to combine with is the moving average technical indicator, in this trading indicator a fx trader should use the Moving Average Cross-over System
Example of MA Crossover Technique Strategy
Once the divergence signal is given, a trader will then wait for the Moving average cross-over system to give a trading signal in the same direction, if there's a classic bullish setup, a trader will wait for the moving average system to give an upwards crossover signal, while for a bearish classic divergence signal the trader should wait for the Moving average cross over system to give a downward bearish crossover signal.
By combining the classic divergence signals with other trading indicators this way, a trader will be able to avoid whip-saws in trading the classic divergence 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 & bottoms.
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