How To Trade A Divergence – A Step By Step Trading Guide
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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.
A RSI divergence
#1 Revisiting the RSIDivergences 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.
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.
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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 the MA?
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