The dream of every trade is to take a low-risk, high-reward shot at making a big splash in the market. This is exactly what skilled traders are able to do when they trade divergences.
It is possible that you can hold a long position and watch the unrealized gains that you have slip away if the market reverses course on you. What if there was a better way to set your entries and exits so this wasn’t such a big problem?
Well, there is.
Divergence trading is when you look at the price action and the movement of specific indicators and compare the two.
When they are out of sync, this may be a sign that you should try to get on the opposite side of the current trend as it may be about to reverse.
You can use any indicator that you like for this process. Many people use something like the Stochastic, but you are also always welcome to use the RSI, the MACD, CCI, and others. The idea is that you are taking note when price action and the indicator of your choice have diverged from one another.
What Exactly is Divergence Trading?
When you think of divergence trading, think in terms of higher highs and lower lows.
When price is making higher highs, you would expect the oscillator to also be making higher highs. And vice versa… If price is making lower lows, you’d expect the oscillator to make lower lows, as well.
If they are not in sync, price and the oscillator are diverging from one another — and that’s why it’s called divergence trading.
See below for an example of Bullish Regular Divergence (which we’ll discuss in detail in a futurue article):
It can be very profitable to find divergences because they are often indicative of the top or bottom of a trend. When traded correctly, it can mean that you get in a trade at the very best price. That is what everyone dreams of, and that is exactly what you can pull off when you work on this just right.
Price and momentum tend to move hand and hand quite nicely with one another. When you see that they are diverging from each other for any reason, this may be a sign that you need to get in on a trade and make some money.
There are two different types of divergence, regular and hidden.
We will get more into this in future articles, but just know that both types are important to include in your arsenal of tools that you need for trading in the markets. The more you learn about divergences, the better prepared you will be to trade them when you are called upon to do so.