Divergences are one of my favorite trading concepts because they offer very reliable high-quality trading signals. Although indicators are somewhat lagging
– just like price action is lagging too – when it comes to divergences,
this lagging feature is actually going to help us find better and more
reliable trade entries as we will see below. Divergences can not only be
used by reversal traders, but also trend-following traders can use
divergences to time their exits. In my own trading strategy, divergences are a big part.
What is a divergence?
Let’s start with the most obvious question and explore what a
divergence really is and what it tells you about price. You’d be
surprised how many people get this wrong already. A divergence forms on your chart when price makes a higher high, but the indicator you are using makes a lower high. When your indicator and price action are out of sync
it means that “something” is happening on your charts that requires
your attention and it’s not as obvious by just looking at your price
charts. Basically, a divergence exists when your indicator does not “agree”
with price action. Granted, this is very basic and we will not explore
more advanced divergence concepts and see how to trade them, but it’s
important to build a solid foundation. Bearish and bullish divergence. Price and indicator are out of sync. Divergence foreshadows reversal.
A RSI divergence
#1 Revisiting the RSI Divergences work on all indicators, but my favorite by far is the RSI (Relative Strength Index).
The RSI compares the average gain and the average loss over a certain
period. So for example, if your RSI is set to 14, it compares the
bullish candles and the bearish candles over the past 14 candles. When
the RSI value is low, it means that there were more and stronger bearish
candles than bullish candles over the past 14 candles; and when the RSI
is high it means that there were more and larger bullish candles over
the past 14 candles. #2 When does a RSI divergence form? Understanding when your indicator is high or low is important when it
comes to interpreting divergences and I generally encourage traders to
look beyond the squiggly lines of their indicators to explore what it
really does. During trends, you can use the RSI the compare the individual trend
waves and so get a feeling for the strength of the trend. Here are the
three scenarios and the screenshot below shows every single one: (2) Typically, the RSI makes higher highs during a healthy and strong
bullish trends. This means that there were more and larger bullish
candles in the most recent trend wave than there were compared to the
previous wave. (1) When the RSI makes similar highs during an uptrend it means that
the momentum of the trend is unchanged. When the RSI makes an equal high
high, it does not qualify as a divergence because it just means that
the strength of the uptrend is still up and stable. (3) When you see that price is making a higher high during a bullish
trend, but your RSI makes a lower high, it means that the most recent
bullish candles were not as strong as previous price action and that the
trend is losing momentum. This is what we call a divergence and in the
screenshot below, the divergence signaled the end of the uptrend and it
makes a downtrend possible. #3 Conventional technical analysis is flawed Classic technical analysis tells us that a trend exists when price
makes a higher high – but like too often, conventional wisdom is seldom
right and usually simplifies things too much. A trader who only relies
on highs and lows for his price analysis often misses important clues
and does not fully understand market dynamics. Even though a trend could
look “healthy” at first glance (higher highs and higher lows), it might
be losing momentum at the same time. Spotting a divergence on your momentum indicator, thus, tells you
that the dynamics in the trend are shifting and that, although it could
still look like a real trend, a potential end of the trend could be
near.
How to trade a divergence – the optimal entry
I am a pure reversal trader
and counter trend trades after divergences are my bread and butter
trades. Over hundreds of trades I have confirmed with my records that by
adding a moving average to my entry criteria, I can enhance the quality
of my trades significantly.
A divergence does not always lead to a strong reversal and
often price just enters a sideways consolidation after a divergence.
Keep in mind that a divergence just signals a loss in momentum, but does
not necessarily signal a complete trend shift.
To avoid trade entries that don’t go anywhere, I highly suggest
adding a 20-period moving average to your charts. When you then see a
divergence, you would only enter a trade if price also breaks the moving
average afterward. Such a scenario is much more likely to lead to a
real trend reversal and you can avoid a lot of market tops where price
just hovers sideways. The screenshot below shows two divergences during the ongoing
uptrend, but neither stopped the trend. However, price never broke the
moving average (in white) and the moving average criteria would have
kept the trader out of losing trades. This is where the lagging nature of indicators actually helps us
traders. When trading reversals, most traders try to predict a reversal
before it happens and they sell during uptrends or buy during sell-offs.
A divergence as a signal forces you to wait until price has already
started reversing. I call it “my insurance” because it keeps me out of a
lot of trouble. Together with the moving average rule, you completely
avoid predicting moves and only trade strong and confirmed reversals. The screenshot below shows a great example. We saw a
multi-divergence, but only after price broke the moving average, it gave
us the signal to enter short.
Tip: Location
Location is a universal concept in trading and regardless of your
trading system, adding the filter of location can usually always enhance
the quality of your signals and trades. Instead of taking trades just
based on a divergence signal, you’d wait for price to move into a
previous support/resistance zone and only then look for divergences and
trend shifts to time entries. The screenshot below is a great example:On
the left side you see an uptrend with two divergences. However, the
first one completely failed and the second one resulted in a massive
winner. What was the difference? When we take a look at the higher time
frame on the right we see that the first divergences happened in the
middle of nowhere and the second divergence formed at a very important
resistance level (yellow line and yellow arrow). As a trader, you first
identify your support/resistance zones and then let price come to you.
Such an approach will impact your performance in a big way. Divergences are a powerful trading concept and the trader who
understands how to trade divergences in the right market context with
the correct signals can create a robust method and effective way of
looking at price. If you want to learn more about divergences and how to trade reversals, you can take a look at our trading courses where you will learn our whole strategy step by step.
Hello Marco, typically, I place it above the high/below the low and add some extra
padding to avoid stop runs and volatility spikes which happen often
around those levels. Rolf
Hi Rolf, Thanks for your article. Very helpful! Do we have to wait until the
candle close below/above the 20 EMA for us to take the trade or just
enter right away when we see the break occurs? Thank you again,
King
Hi Rolf,
I have traded divergence of MACD indicator. But I had trouble
identifying true divergence move of reversal. Your article will greatly
improve my trading plan.
Hi Rolf, thank you for very informativne article. Can you pls tell us what is
your winning rate and average risk:reward ratio of your divergence
reversal trade? I’m a main trend following swing trader, but I’m
thinking of incorporating your reversal trading style to earn some bucks
out of retracement waves as well. It’s very hard for me to wait for
price to retrace 50 – 61.8 % before taking positions.
Hi,
sure. I trade different types of reversals and depending on the quality
and the criteria present, the winrate varies between 40% and 60% for the
best setups. Rolf
Hello Marcos, thanks for the kind words. I leave the 14 period settings. I trade
mostly on the 4H timeframe so the 14 periods capture roughly 2.5 days
which is sufficient to analyze swings and trend waves. Usually, you
don’t need the indicator to know it’s a divergence, but it’s an
additional and objective confirmation. Rolf
Hi Rolf, Your inputs are awesome! I have started reading it all. It caught my attention lately this area “divergence”. You have reply
to Marcos that even without the RSI indicator you can identify that it
is divergence. As we all know indicator have lag time. As an additional to your great piece- would you be so kind to tell us how to spot divergence before the RSI confirm it. Thanks.
This is magic, had I knew this at the beginning of my trading career I would have been far But will still make it worthwhile *When your indicator and price action are out of sync it means that
“something” is happening on your charts that requires your attention* You changed my trading game for the best
Hello Rolf. Thanks for sharing this valuable piece of
information. I’m not sure if you answered this question already, but how
do you determine an exit strategy/know when the “play is over”? Is
there a way that you can know when the counter trend is over? thanks again!
-john
Hello John, in a nutshell, I trail my stop along the 20 SMA and/or based on
support/resistance levels. I will make a detailed article on trade
exits, though, soon. Rolf
Hi Rolf, Thanks a lot for such a wondorful article, however in the examples
above you have only considered the best set up for divergences when the
RSI is ONLY above 70 for bulish trends. Is this is a necessity for the
best set ups or can it happen without it under your observations? Cheers
Ram
Hi Rolf, Lets say after I spotted the divergence signal and open a trade after
price action confirmation, do I need to come back and check on the
chart again for any new divergence signals again? It would have new
divergence that affect our trading plan? Thx
Hello, what do you mean with new divergence signal? Can you please attach a
chart example with a tradingview link so that I can get a better idea. Rolf
hello rolf, thank for a great article, i read two different
divergence while trading rsi, called regular divergence and an unknown
concept called hidden divergences, can you pls explain the term hidden
divergence and if you can make a video on it
thanks
Hello, I don’t think hidden divergences are really helpful. Stick to the
common divergences – they are very good if the context around them
agrees. Rolf
Rolf, Just two queries please: 1. Do you use the 20 SMA or 20 EMA? 2. Does the candle have to penetrate the moving average or close the other side of th Many thanks, John.
Hello Sir,
First of all thank you for sharing such a great technique. I have
some doubts. I am an Intraday trader and use time frame 1 minutes and 5
minutes candles. I am using RSI (9) and (14). I get more divergence
signals in 1 minute candles (60-70% accuracy) than 5 minutes. So please
guide which time frame & RSI get more accuracy in intraday. Also
please tell any other indicator to support the RSI other than Moving
Average to get more accuracy.
Hello Vinu,
thanks for reading our article. I use anything from the Daily, 4H to
1H timeframe for my divergence trading. But it certainly applies to
lower timeframes as well.
Rolf
Hi , very interesting article. I have question regarding the use
of MA 20 – Which movieng averadge simple or exponential / or it does not
matter?
thank you
Ondrej
Hi Rolf,
A wonderful article which explains RSI in detail. Thank you so
much. One request, can you write one article or make a video to explain
when to Exit.
That is a very difficult question and not something you can just explain in a blog post.
In our private forum (http://pro.tradeciety.com/) we talk and discuss trade management and exits in great detail every day.
Rolf
typically, I place it above the high/below the low and add some extra padding to avoid stop runs and volatility spikes which happen often around those levels.
Rolf
Thanks for your article. Very helpful! Do we have to wait until the candle close below/above the 20 EMA for us to take the trade or just enter right away when we see the break occurs?
Thank you again,
King
there are a lot of false breakouts and a close below/above the moving average is a much stronger signal.
Rolf
I have traded divergence of MACD indicator. But I had trouble identifying true divergence move of reversal. Your article will greatly improve my trading plan.
All the best and thanks for leaving a comment.
Rolf
thank you for very informativne article. Can you pls tell us what is your winning rate and average risk:reward ratio of your divergence reversal trade? I’m a main trend following swing trader, but I’m thinking of incorporating your reversal trading style to earn some bucks out of retracement waves as well. It’s very hard for me to wait for price to retrace 50 – 61.8 % before taking positions.
sure. I trade different types of reversals and depending on the quality and the criteria present, the winrate varies between 40% and 60% for the best setups.
Rolf
I trade purely off the RSI, but most momentum indicators such as the Stochastic should work in a very similar way.
Rolf
I would like to ask though, do you always set your RSI at 14 days or do you change it on different situations?
Thanks
thanks for the kind words. I leave the 14 period settings. I trade mostly on the 4H timeframe so the 14 periods capture roughly 2.5 days which is sufficient to analyze swings and trend waves. Usually, you don’t need the indicator to know it’s a divergence, but it’s an additional and objective confirmation.
Rolf
Your inputs are awesome! I have started reading it all.
It caught my attention lately this area “divergence”. You have reply to Marcos that even without the RSI indicator you can identify that it is divergence. As we all know indicator have lag time.
As an additional to your great piece- would you be so kind to tell us how to spot divergence before the RSI confirm it. Thanks.
I actually made a video about that: https://www.youtube.com/watch?v=Eg-Q6pZ8ptQ
Best regards
Rolf
*When your indicator and price action are out of sync it means that “something” is happening on your charts that requires your attention*
You changed my trading game for the best
Rolf
Rolf
thanks again!
-john
in a nutshell, I trail my stop along the 20 SMA and/or based on support/resistance levels. I will make a detailed article on trade exits, though, soon.
Rolf
Thanks a lot for such a wondorful article, however in the examples above you have only considered the best set up for divergences when the RSI is ONLY above 70 for bulish trends. Is this is a necessity for the best set ups or can it happen without it under your observations?
Cheers
Ram
the stronger the previous trend and the higher the RSI, the better the reversal with the divergence will be.
Rolf
Lets say after I spotted the divergence signal and open a trade after price action confirmation, do I need to come back and check on the chart again for any new divergence signals again? It would have new divergence that affect our trading plan?
Thx
what do you mean with new divergence signal? Can you please attach a chart example with a tradingview link so that I can get a better idea.
Rolf
Rolf
thanks
I don’t think hidden divergences are really helpful. Stick to the common divergences – they are very good if the context around them agrees.
Rolf
I appreciate it.
Rolf
Just two queries please:
1. Do you use the 20 SMA or 20 EMA?
2. Does the candle have to penetrate the moving average or close the other side of th
Many thanks,
John.
I use the 20 period SMA. I wait for the full candle close.
Rolf
I am putting together new material which explains my whole strategy. Stay tuned
Rolf
First of all thank you for sharing such a great technique. I have some doubts. I am an Intraday trader and use time frame 1 minutes and 5 minutes candles. I am using RSI (9) and (14). I get more divergence signals in 1 minute candles (60-70% accuracy) than 5 minutes. So please guide which time frame & RSI get more accuracy in intraday. Also please tell any other indicator to support the RSI other than Moving Average to get more accuracy.
thanks for reading our article. I use anything from the Daily, 4H to 1H timeframe for my divergence trading. But it certainly applies to lower timeframes as well.
Rolf
Beautifully explained
Thanks
Rolf
thank you
Ondrej
thanks and I am glad you found it helpful.
I use the simple moving average.
Rolf
I use the 20 SMA
http://www.tradeciety.com/my-favorite-indicator-that-helped-me-become-a-better-trader/
Rolf
A wonderful article which explains RSI in detail. Thank you so much. One request, can you write one article or make a video to explain when to Exit.
In our private forum (http://pro.tradeciety.com/) we talk and discuss trade management and exits in great detail every day.
Rolf