The main target of the technical analysis is to determine entry and exit points, or levels, as well as the trend reversals. There are dozens of forex trading strategies helping traders to maximize profits on trends continuation, signalling entry levels during retracements and pullbacks. However, the number of effective systems is not so large due to the difficulty of the task - to find reversal points. Several technical methods exist, and most of them are based on identifying a moment when the trend gets exhausted and the bullish or bearish price action loses its momentums. One of such trading systems is based on technical divergences. In order to get the best efficiency of this technique, we need to clarify the definition of the divergence.
Divergence occurs when the price shows higher highs in an uptrend while a technical indicator shows lower highs. It is the same rule, but in the opposite, for a downtrend - lower lows of the price are followed by higher lows of the indicator. One important disclaimer notes that the middle level of the indicator, dividing two peaks, should not cross the zero level of the indicator.
Before we explain further details of this particular forex trading strategy, we need to remind that it is a reversal strategy which means that positions will be opened mainly against the current trend which is quite risky. So it’s required to use a defensive approach if the price is not moving in the right way, placing tight stop-loss orders or exiting the deal in the right moment. Nevertheless, this forex trading strategy based on divergences has more than 80% efficiency and works well in most cases.
The best timeframe here is H1, whereas shorter timeframes have a large number of fake signals. Longer timeframes are also applicable here, although the frequency of the signals is much lower for the daily chart, for instance, compared to the hourly one. The best currency pair to choose is EUR/USD or any other heavy-volume asset, as the more volume on the market is, the more vulnerable the asset is for the technical analysis, and thus, the effectiveness of this particular trading system.
The main technical indicator is MACD (Moving Average of Convergence and Divergence), and this is why the name of the strategy is related to the divergence. It is worth of noticing that the MACD indicator is rather slow, lagging from the price action. This is why an additional indicator is used here and it is the RSI fast oscillator (Relative Strength Index). Both indicators are used with default settings, however, some traders prefer to change the period of RSI to 13 instead of the standard 14. Anyway, any trader should test a strategy before using it, so you will have a chance to pick up the best choice most suitable for your particular trading style. Important: bullish or bearish divergence of the MACD indicator must be confirmed by the same divergence on RSI oscillator before entering the market!
One more advantage of this forex trading strategy is that it allows not only to determine reversal points of a trend but also to identify levels of taking profits from previous entries, opened with some other technical or fundamental observations. Sometimes divergences are not played out with a sharp reversal price action but in a sideways range. This is not the worst-case scenario as traders can easily exit the position with small profits or at zero level. It happens much more rarely when the current trend is so strong that it breaks a divergence on one timeframe, however, that precedent creates an additional divergence on a longer timeframe which leads to the reversal sooner or later.
Here comes the example of the divergence on the EUR/USD H1 chart below.
The first example is the bearish divergence and it signalled the bullish spike’s reversal perfectly. The second example is the bullish reversal serial divergence (three consecutive peaks of the price are followed by the same number of lows in both indicators). In the second case, probably, we don’t have a complete reversal with the too far development of the bullish price action, however, the signal occurred correctly on the level of taking profits from previous short positions.
One more crucial rule is applicable for this forex trading strategy: the divergence considers as worked out when both lines of MACD indicator cross the zero level and RSI oscillator crossed the 50% level. It is better to take profits and stop buying/selling the asset once that condition occurs.