How to Trade Classic Bullish Divergence and Bearish Divergence - Classic Bullish vs Classic Bearish Divergence

In Forex 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 and most traders don't 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 2 types, based on the direction of the trend:

1. Classic Bullish divergence
2. Classic Bearish divergence

Classic Bullish Divergence

Classic bullish divergence set-up occurs when price is making lower lows (LL), but oscillator is making higher lows (HL). The example below shows a picture of this setup.

Classic Bullish Trade Divergence

This example uses MACD indicator as a divergence indicator.

From the above example the price made a lower low(LL) but technical indicator made a higher low(HL), this portrays there is a divergence between the price and the technical indicator. This 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 price went lower the volume of 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 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 portrays there is a divergence between the price and the technical indicator. This 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 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 trend.

In the example above, if you as a trader had used divergence setup to trade you would have gotten good signals to enter or exit the trades at an optimal point. However, divergence signals just like other indicators, is also prone to whipsaws. That is why it's always good to confirm the divergence signals with other indicators such as the RSI, Moving Averages & Stochastic Oscillator.

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 indicator a trader should use the Moving Average Cross-over System

Examples of MA Crossover Technique 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 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 cross-over signal.

By combining the classic divergence signals with other indicators this way, a trader will be able to avoid whip-saws when it comes to 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 and bottoms.