In the context of Forex trading, divergence refers to a discrepancy between the price action of a currency pair and an oscillator indicator. Oscillators are technical analysis tools used to identify overbought or oversold conditions in the market, as well as potential trend reversals. Common oscillators include the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Stochastic Oscillator, and others.
There are two main types of divergence: regular divergence and hidden divergence.
Regular divergence occurs when the price of a currency pair moves in the opposite direction of the oscillator indicator.
There are two types of regular divergence:
This happens when the price of a currency pair makes lower lows, but the oscillator indicator forms higher lows. It suggests that the downtrend is losing momentum, and a potential bullish reversal might occur.
This occurs when the price of a currency pair makes higher highs, but the oscillator indicator forms lower highs. It suggests that the uptrend is losing momentum, and a potential bearish reversal might occur.
Divergences not only signal a potential trend reversal but can also be used as a possible sign for a trend continuation (price continues to move in its current direction). The so-called hidden divergence helps to determine this. There are two types of hidden divergence:
Bullish Hidden Divergence
This occurs when the price of a pair makes a higher low than it did before, but the oscillator makes a lower low, then you may be looking at a hidden divergence that is pointing towards trend continuation.
Bearish Hidden Divergence
The opposite of the bullish divergence is a bearish divergence. If the price has made a lower high, but the oscillator has made a higher high, then the trend may be ready to continue downward.
Divergence can be used to trade in two ways:
To enter a trade.If you see a divergence, you can enter a trade in the direction of the divergence. For example, if you see a regular bullish divergence, you could enter a long trade.
To exit a trade.If you are already in a trade, you can use divergence to exit the trade. For example, if you are in a long trade and you see a regular bearish divergence, you could exit the trade.
Using divergence in Forex trading can be helpful as it provides traders with valuable signals about potential trend reversals or trend continuation. However, it's important to note that divergence signals may be false and should not be taken in isolation. It is advisable to use divergence in conjunction with other technical analysis tools and price action analysis to increase the probability of successful trades.