DIVERGENCE TRADING SETUPS SUMMARY
Classic Bearish - HH price, LH indicator - Indicates underlying weakness of a trend - Warning of a possible change in the trend from up to down.
Classic Bullish - LL price, HL indicator - Indicates underlying weakness of a trend - Warning of a possible change in the trend from down to up.
Hidden Bearish - LH price, HH indicator - Indicates underlying strength of a trend - Mainly found during corrective rallies in a downtrend.
Hidden Bullish - HL price, LL indicator - Indicates underlying strength of a trend - Occurs mainly during corrective declines in an uptrend.
Illustrations of the divergence terms:
M-shapes dealing with price highs
W-shapes dealing with price lows
These are the shapes to look for when looking for when using these setups.
One of the best indicator for this setup is the MACD Indicator - as a Forex signal MACD divergence is a high probability setup to enter a trade. But as with any signal there are certain precautions that have to be observed to make this signal a high probability setup. Getting straight in to a trade as soon as you see this setup is not the best strategy. This setup should be used in combination with another technical indicator to confirm the direction of the currency trend. A good system to combine with is the moving average crossover system.
Be aware this setup on a smaller time frame is not so significant. When divergence is seen on a 15 minute chart it may or may not be very important as compared to the 4 hour chart time frame on MetaTrader 4 platform.
If seen on a 60 minute chart, 4 hour chart, or daily chart time frame, then start looking for other factors to indicate when the price may react to the divergence.
This brings us to a key point when using this signal to enter a trade: on a higher time frame MACD divergence can be a fairly reliable indicator of a change in price direction. However, the big question is: WHEN? That is why getting straight in to a trade as soon as you see this setup is not always the best strategy.
Many investors get caught out by entering the market too soon when they see MACD divergence. In many cases, price has still got some momentum to continue in the current direction. The investor who has jumped in too soon can only stare at the screen in dismay as price shoots through his stop loss taking him out.
If you simply look for this setup without any other considerations you will not be aligning yourself with the best odds, so to increase the odds of making a successful trade you should also look at other factors, specifically other indicators.
What other factors should you consider when using this setup?
1. Support, Resistance and Fibonacci levels on higher time frames
Another way to greatly increase the odds of a winning trade is to observe the higher chart time frames before opening an order based on the lower time frames.
If you observe that the hourly, 4 hour or daily Forex chart has met a major resistance, support or Fibonacci level then the probability of a successful trade based on divergence on a lower time frame at this point increases.
2. Reward to risk ratio
And finally, when looking for divergence, it is very important that you enter the trade correctly, so that you have a good risk/reward ratio and only open transactions that have more profit potential than what you are risking. If you understand how to enter a transaction properly, you can measure your risk/reward before you open a transaction. That way, you can only choose to open orders that offer a favorable ratio.
Finally, when used correctly and combined with other technical indicators to confirm this signal, divergence setup can offer huge profit potential.