Divergence

1 on 1: Divergence © 2006 W. R. Booker II & Maxwell Fox. All rights reserved forever and ever. And ever. This ebook is part of a comprehensive program to train you to successfully trade currency. Alas, you’ll probably lose money. We all do at first. Rob’s not liable if, based upon the nformation you read here, you lose money, make money, turn into a woodchuck, possum, or other furry creature. You have to work hard, study a lot, and dedicate yourself mentally. Don’t ever give up

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di·ver·gence (d -vûr j ns, d -) n.1: A moving or spreading apart in different directions from a common point. In trading, “Divergence” is a term used to describe the phenomenon of price making one pattern, and an indicator making the opposite. I will outline two main categories of Divergence. I will call them: • Regular Divergence (RD) & • Hidden Divergence (HD) Regular Divergence is a counter trend signal. RD attempts to show that a trend may soon be coming to an end or at least to a pause with a slight retracement. Hidden Divergence is a trend confirming signal. HD attempts to show you that the pause or retracement of the trend may be nearing its end, and the trend may soon be ready to continue. There are bullish and bearish types of both Regular and Hidden Divergence. You can use pretty much any oscillator to show divergence, but some of the most popular are: MACD, Stochastics, RSI, CCI, and Momentum. I will be using the MACD Histogram in the examples. Before we continue, I would like to warn that upon first attempt to comprehend Divergences, it is possible that your brain may overheat, and blow your radiator or head gasket. I will try to make it as simple as possible, but don’t say I didn’t warn you.

3 Regular Divergences: Bullish Regular Divergence: Bullish RD occurs in a downtrend and signals an end to the downtrend and a potential bullish correction. Below is an example.

You can see where I drew the red lines, price made lower lows, constituting the down trend. But the MACD Histogram made progressively higher lows. “What’s up with that?” you may be wondering. That, my friend, is Bullish Regular Divergence. It is a signal that the strength of the downtrend is waning. And as you see in the chart above, the trend is beginning to reverse.

4 Bearish Regular Divergence: Bearish RD occurs in a uptrend and signals an end to the uptrend and a potential bearish correction. Below is an example.

You can see that we were in an uptrend by the higher highs in price that I highlighted with the rising red line. But hold on a minute! The MACD Histogram made lower highs. The direction of the indicator is Diverging from the direction of price! This is telling us that the up trend may be coming to an end soon, and we may see a bearish correction sometime in the near future. And that is exactly what happened on the right side of the chart. That wasn’t so bad right? Pretty straight forward stuff. But it is Hidden Divergence that makes peoples brains melt down.

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Hidden Divergences: Bullish Hidden Divergence: Bullish Hidden Divergence occurs in an uptrend, and signals a continuation of the trend. Below is an example.

Here we have an uptrend. It is highlighted by the red line showing a series of higher lows. But the MACD Histogram stretched way down low and made a lower low. This is a bullish signal! It shows us that the trend took a little break, but it did not take much of a correction to make the MACDH to fall way down into oversold land. I like to think of the MACDH as a slingshot getting pulled extra far down in order to shoot price upward.

MACD

Valley

6 Bearish Hidden Divergence: Bearish Hidden Divergence occurs in a downtrend, and is a signal of continuation of that downtrend. Below is a chart example.

The downtrend is defined by the lower lows and lower highs. I highlighted the lower highs with the red line. But the other red line shows that the MACD Histogram is making higher highs! Price made a little tiny rally, but it made the MACD Histogram go on a rampage into overbought territory. This is Bearish Hidden Divergence. It is a signal that the trend will soon continue. And so it does on the right side of the chart. Ok, this is all fine and dandy, and it looks like divergence kind of works, but there is something missing…right? Like trade entry signals, and stop loss placement, and profit targets. Divergence is NOT a system on its own. You need to set other rules to define when you will get in and out of a trade once you identify divergence. For trade entry you can use trendlines, Fibonacci retracements, indicator levels or turning points, moving average crossovers, or Dionne Warwick. For stops, I usually like to place them beyond a recent high or low. I also like to use a recent high or low for a profit target, or break even point. In a strong trend, I would tend towards having a recent high or low be my break even point, and let the trend carry me to more profit. In a market with less directional momentum, I would tend to take all the profit at the recent high or low.

7 A system worth testing: • • • •

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Go back in history as far as you can on your chart. Plot the MACD Histogram on your chart. Click forward one candle at a time until you find an example of divergence Draw a trendline over the recent highs if it is bullish divergence (the trendline should be descending) o Draw the trendline under the recent lows if it is a bearish type of divergence (the trendline should be ascending) Place a horizontal line below a recent low for a buy trade. This will be your stop loss line. o Place a Horizontal line above a recent high for a sell trade. Place a horizontal line at a recent high for a profit target for a buy trade. o Place a horizontal line at a recent low for a profit target for a sell trade. Consider your trade active when you get a candle closing on the other side of the trend line. Click forward one candle at a time until one of your horizontal lines is hit. Record your profit or loss Click forward until you spot another divergence.

Do this over and over until you have 60 trades. Then do it again with some new rules that you make up based on your ideas & observations from the first testing session. After some of this, you will not only be a divergence pro, but you will be a pro trader! Quick Recap: o Bullish Regular Divergence: Counter Trend – Lower Lows in Price & Higher Lows on Oscillator o Bearish Regular Divergence: Counter Trend – Higher Highs in Price & Lower Highs on Oscillator o Bullish Hidden Divergence: Trend Continuation – Higher Lows in Price & Lower Lows on Oscillator o Bearish Hidden Divergence: Trend Continuation – Lower Highs in Price & Higher High on Oscillator