Divergences are extremely popular when trading because they have a great advantage: they are visible and makes buying the binary options fairly easy. In order to have a divergence, a trader needs to compare the price for an underlying security (currency pair, indexes, stock, etc), with an indicator, preferably an oscillator as trend indicators are not offering real diverging moves.
The oscillator is basically confirming or not the actual movements the price is making and this is when divergences appear. In order for a divergence to be valid, one should compare the moves made by both price and oscillator and when there’s a difference between the two, it is said that they are moving in a diverging way.
It should be noted that price has the tendency to make fake moves most of the times so the thing to be done here is to stick with the oscillator all the time.
- If the oscillator is on a rising path but price is on a falling path, it is said that the divergence is bullish and therefore we should buy call options as a consequence.
- If the oscillator is on a falling path but price is on a rising one, it is said that the divergence is bearish and therefore we should buy put options instead.
The expiration date is to be given by the time frame the divergence is being spotted and of course by the trading plan/strategy the trader has. When looking for a divergence between price and an oscillator, then always look for one of the two to be “lying”, as they both cannot say the same story, as if they do, then that would not be a divergence.
Follow The Oscillator
As a rule of thumb, when looking at a divergence, a trader should always stay with the oscillator as price is the one that gives the fake move. It is normal to be like that as the oscillator is being plotted taking into account more candles that closed in the past and so a current value is printed. For example, when plotting an oscillator on the screen, one can set the period the oscillator is taking into consideration when plotting the values. If that period is, say, fourteen, then that means that the oscillator is taking into account the last fourteen candles before plotting the actual value, while price is, of course, referring to only one candle.
This means we should always stick with the oscillator as the info contained there is the most comprehensive one and therefore if the divergence is bullish, call options are recommended, while if the divergence is bearish, then put options are the ones that should be traded.
With Divergences, Be Mindful of the Time Frame
It should be noted though that divergences are extremely tricky as the time frame is key. If a divergence is forming on a bigger time frame, for example on a daily chart, then trying to pick the right expiration date can be difficult as there might just not be any expiration that big.
Divergences imply picking a top or a bottom and we all know that this is the holly-grail in trading. Trying to pick a trop or a bottom means that you know when the market is turning and this makes divergences extremely visible and loved by traders from all over the world. Because they are that visible, trading algorithms are looking at them as well and for that reason they fail quite a lot.
Divergences with Short Term Expiration
The way to go in trading divergences is to stick with the lower time frames, hourly chart being the bigger time frame to consider as this means smaller expiration dates. If, for example, a divergence is identified on the five minutes chart, then even trading hourly expiration dates can be difficult, so look for a bigger one even for such a small time frame.
On the other hand, if the divergence is on the hourly chart, then we can basically trade whatever the expiration date we want as, if the divergence appear on the second part of the month, then trading end of month expiration date is possible as well. More than end of month is pretty tricky and difficult to trade as one needs a broker that has the possibility to offer that kind of expirations. However, it is not impossible.
As a consequence, trading with divergences can be really rewarding as a bullish divergence leads to BUY contracts/CALL options and a bearish divergence leads to buying SELL contracts/PUT options. The way to go is to trade call options in the first instance and put options in the second one, with the emphasis when choosing the expiration date to be on the time frame the divergence appears on.