Divergences are looked at for one reason and one reason only: to find fake moves market makes and then to trade based on the outcome the analysis shows.
Typically, oscillators are the ones favored for spotting a divergence and the most popular ones for doing this are: RSI (Relative Strength Index), CCI and (Commodity Channel Index). However, any oscillator can be used to spot a divergence because in the end they show nothing but oversold and overbought levels, so one in the first case one wants to buy the asset, while in the latter one wants to sell.
In order for a trader to trade divergences, it is important to know what divergences are and what to look for. Traders should look at the movements price makes and the movements the oscillator makes.At one moment of time, they will move in different directions, or will differ in amplitude and size of the move. That is a divergence.
Bullish and Bearish Divergencies
Divergences can be bullish or bearish,
- a bullish divergence means CALL options/BUY CFDs should be traded as higher values are expected, while
- a bearish divergence means SELL contracts or PUT options should be bought as lower values are be expected.
It is also important to take into account the nature of the oscillator to be used and what are its specifications and calculation mode. For example, RSI and CCI are different in nature and may show different things.
Some trading platforms even show the CCI under trend indicators instead of the oscillators category and this may be confusing as well.
A divergence is forming when price is showing one thing and the oscillator another one as from that moment of time one of the two is lying. Being able to know on which to rely upon is key. We always say it is more important to rely on indicator rather than price for a very simple reason: the indicator takes into account a bigger period of time than price as price is referring to one single candle while the indicator to more than one.
The above represents a huge advantage for understanding the concept of a divergence and for taking the right decision when it comes to forex trading.
The key is to look at price and the indicator: if price is making a new high when compared withthe previous high, it is called that it is making a series or higher highs. This is the very basic need for trend formation. Most of the times, the indicator is showing the same series of higher highs, but when it is not, it is called that price and indicator are diverging.
Usually that is enough to trigger a call option in bearish market and a bullish divergence as well as a put option in a bullish market and a bearish divergence.
Like mentioned at the start of this article, indicators suitable for divergences to form are CCI, RSI, and any other one can find in the oscillator category. Being an oscillator, or trading with one it means that the trading platform will place the oscillator at the bottom of your chart. This way, it is easier for traders to spot this divergences.
As always, the usual caveat applies here too: the bigger the time frame the indicator is being plotted, the bigger the expiration date should be considered as is you are looking at a divergence that is forming on the daily chart for example, then finding the perfect striking price is a bit difficult.
It is a saying that divergences can last more than a client’s account is solvent and this means it is tricky.
Filter the Trading Sessions
One way to look for divergences when trading is to wait for periods with low volatility to appear. Such periods are being given by the Asian session, when holidays are coming (like the month of August or Christmas) or when trading week is starting as Monday is the perfect day for trading ranges.
If that is the case, to take Mondays as the perfect days to find divergences with indicators, then go on the five minutes chart and plot the indicator for spotting the divergence. When it comes, end of day expiration date should be recommended.
This does not mean that the trader is actually waiting for one day for the option to expire. No. If the trade is being taken in the second half of the day than only a few hours should see if the option expired in the money or out of the money.
More details about all the above and how to spot divergences with different oscillators are to be found by watching the two videos in our article.