Forex Divergence Trading Strategies

Divergence trading is a key strategy in Forex. It involves spotting differences between price and indicators. These differences can signal market reversals.

Traders use this method to find entry and exit points. Learn how to apply Forex divergence strategies for better trading results.

What is Forex Divergence?

For starters, let’s clarify what Forex divergence is all about. Simply put, divergence occurs when the price of a currency pair — moves in the opposite direction of a technical indicator.

This discrepancy often signals a potential trend reversal or continuation. Therefore, this makes it a valuable tool for traders.

For instance:

Imagine the price of EUR/USD is making higher highs. However, the Relative Strength Index (RSI) is showing lower highs.

This mismatch is what we call divergence.

Types of Divergence

There are two main types of Forex divergence trading strategies you should know about:

1. Regular Divergence

Regular divergence often signals a potential trend reversal. It comes in two flavors:

• Bearish Regular Divergence: Price makes higher highs, but the indicator makes lower highs.

• Bullish Regular Divergence: Price makes lower lows, but the indicator makes higher lows.

2. Hidden Divergence

Hidden divergence typically suggests a trend continuation. It also has two types:

• Bearish Hidden Divergence: Price makes lower highs, but the indicator makes higher highs.

• Bullish Hidden Divergence: Price makes higher lows, but the indicator makes lower lows.

How to Spot Divergence

Now that you know the types, how do you spot divergence? Here’s a simple step-by-step guide:

1. Choose your favorite indicator (RSI, MACD, or Stochastic are popular choices).
2. Look for peaks and troughs in both the price and the indicator.
3. Compare the directions of these peaks and troughs.
4. If they’re moving in opposite directions, you’ve got divergence!

For example:

Let’s say you’re using the RSI on a daily EUR/USD chart.

The price shows highs of 1.2000, 1.2050, and 1.2100 over three days.

However, the RSI shows readings of 70, 68, and 65 for the same period.

This is a classic case of bearish regular divergence!

Implementing Forex Divergence Trading Strategies

Now, let’s get to the exciting part – how to use these Forex divergence trading strategies in real life! Here’s a simple approach:

1. Identify the divergence (regular or hidden).
2. Wait for a confirmation candle (a candle that closes in the expected direction of the reversal).
3. Place your trade in the direction of the expected move.
4. Set a stop loss just beyond the recent swing high/low.
5. Target a profit at least twice your risk.

Let’s walk through an example.

You spot a bullish regular divergence on the GBP/USD 4-hour chart.

The price has made a low of 1.3700, but the RSI shows a higher low.

You wait for a bullish confirmation candle that closes above 1.3720.

You then buy at 1.3725, setting a stop loss at 1.3690 (35 pips risk).

Your profit target could be set at 1.3795 (70 pips reward, twice your risk).

Benefits and Risks of Divergence Trading

Like any trading strategy, Forex divergence trading strategies come with their own set of pros and cons.

Benefits:

• Early signal of potential trend reversals
• Works on multiple timeframes
• Can be combined with other technical analysis tools

Risks:

• False signals can occur
• Requires practice to spot accurately
• Doesn’t work well in ranging markets

To mitigate these risks, always use divergence in conjunction — with other technical analysis tools.

Note: Never risk more than you can afford to lose.

Remember, successful trading is a journey, not a destination. Keep learning, stay curious, and always manage your risk.

Happy trading! May the pips be on your side!