Trading Divergence Part 2

Why Validate?
In yesterday's post I said I would next take a look at how to validate the pattern of divergence between price and a technical indicator. Before I do that, it's worth understanding the reason why that is necessary.

Like all patterns associated with technical indicators, they are easy to "trade" in hindsights. Yesterdays post included a chart that demonstrated divergence - the pattern was in the centre of the chart and it was easy to see the price action that occurred as a result of the divergence. But trading occurs on the right hand edge, so here is an example of divergence from yesterday evening:



This divergence is an indication that the bearish run is losing momentum and that there is potential for an upturn on price. However, as you can see from the chart below, a long trade would have almost certainly have failed:



So validation of the divergence pattern is a process of applying a set of rules to assess whether or not the divergence is sufficiently compelling to place a trade. I'll discuss this in a subsequent post.

Trading Divergence Part 1

Wow, it's been a long time since I have posted anything here, so let's try and get back into a routine. I'll do this slowly, step by step. This post is about trading divergence.

Step 1: Defining Divergence
Most technical indicators are derived from price action over a defined period of time. When you look at the structure of the oscillator in terms of highs and lows, it generally follows the same pattern as price. In particular, if price is in an uptrend, making higher highs, then the oscillator will also make higher highs. Occasionally this pattern fails, and price makes a new high whilst the oscillator fails to make a new high, or makes a lower high (the reverse applies to downtrends). This disconnect between the price and the oscillator is divergence. More specifically, it is regular divergence. There is also a form of divergence known as hidden divergence, which I'll describe some other time.

Technical indicators are often criticized for lagging price action and therefore only delivering insights in retrospect. You can argue whether that is a reflection of the indicators themselves, or the authors of books that describe technical setups in the middle of the chart, as opposed to the right-hand edge - the place where traders have to operate. Divergence however, it very definitely a leading indicator i.e. it precedes price action. It can be used as a warning not to enter a trend following trade, or as a cue to enter a counter-trend trade.

The screenshot below shows divergence between price and both Stochastic and MACD indicators. The divergence is marked with solid blue line segments, and occurs between about 21:00 and midnight of the 16th.



Ignore the red line going across the chart, it's not relevant to this discussion. But notice how the divergence correctly anticipated an end to the immediate downtrend, with a significant upward adjustment following it.

One way to use divergence is just to be aware of it, and not get caught entering a trend following trade when this pattern occurs. But can it be traded directly? Yes it can, but you need to qualify the setup. Because it is a leading indicator, sometimes the adjustment to price does not follow immediately, but there are ways to validate the setup and set entry and exit levels that improve the odds of success.

Coming Soon ... Part 2: Validating the Divergence Pattern ...