Divergence Trading System
I want to propose to you a trading system that I have used practically my entire life as a trader. It is not a system that I have invented, this has been used for a long time in trading (speculation),
although I am going to give my personal vision to this strategy that has been denied and supported by many traders in equal parts.
This is only a small informative guide, I hope it serves to arouse interest in whoever reads it, and that from that starting point they can form a formal and well-defined strategy, which is the key to a successful trading.
First of all, what is it and why is there a divergence?
In any financial market, there are imbalances between the price of an asset and the value it really has. This is called inefficiencies.
If the value is relatively well adjusted to the price of the asset, we will say that the asset is in an efficient market.
When you analyze a market by means of indicators, you are actually analyzing the price, not the value. Determining the value of an asset is somewhat complicated, and in my personal opinion, that is not the role of a speculator.
A trader is not interested in the value that resides in assets, you are interested in exploiting market inefficiencies and speculating on them.
Divergences in an indicator generally exploit these inefficiencies and allow us to foresee when the market may change its course.
That is, to know when the market is going to move in one direction to enter an equilibrium between price and value.
But when does a divergence occur? They occur when prices mark highs or lows in a defined direction, while the indicator It presents them in the opposite direction to what we see in prices.
A divergence does not necessarily indicate that the price is going to turn in another direction. As we well know, an indicator gives us market information, it is not something that works 100% of the time.
A divergence gives us information: the current market movement is losing steam.
It is in our hands as speculators to determine if the signal that an indicator gives us is reliable, or based on our experience, it is a false signal.
The power of most of the indicators that are used is that we are not the only ones using it. For example, many traders use the 200-period moving average as an indicator to chart support and resistance;
Not that the moving average is a magic indicator, its power lies in the fact that many people use it as a reference.
In the case of divergences, one of the most used indicators is the MACD. Note that the name of this indicator is neither more nor less than MOVING AVERAGE CONVERGENCE AND DIVERGENCE.
Therefore, it is a question of looking for a negative difference between the value marked by the indicator and the price of an asset. Let’s see an example:
In this weekly chart of the EURUSD you can see that the MACD indicator makes a decline, while the price has made a new high.
There is therefore a divergence between the price and what the indicator is marking. And indeed you can see how the price subsequently initiates a correction or a trend change.
Now let’s take an example a little more difficult to locate, in this case of GBPUSD the indicator remains flat, but it can be seen that there is no direct correlation between the price and what the MACD indicator marks.
And that after this there is a change of direction in the price of the chart.
It seems like a fairly easy concept to assimilate, although you may still think that there are cases in which it is not fulfilled. True, as I said before, indicators are not all-purpose tools.
But let’s refine this strategy a bit more. For the strategy to be really effective, we must look for one more condition:
The MACD level crosses the zero line before the divergence occurs.
Let’s look at an example of this again:
A true divergence can be seen on this USDCAD chart on H1. As we have seen before, negative correlation between the price and the MACD indicator, with a cross through the zero level of the indicator.
And again we see the same thing on the H1 chart of the EURUSD.
In my personal experience I have noticed that the most important divergences occur between the highest temporalities, that is why I never use them with temporalities less than H1.
And the last step to understanding this strategy is based on noticing one last detail:
Divergences occur at the peaks, highs and lows of the price. Divergences occur continuously, but the ones that are of interest for this strategy are the ones we have named: price peaks.
And, how to know if we are in a price peak? Very simply, if you draw a line between the points and that line crosses price bars, that is not a divergence.
Let’s look at the H1 chart of the EURUSD again. In this specific case, we see that the line drawn between the two points of the MACD cuts price bars. This is not a divergence, in addition, it does not cross the zero line of the indicator.
I propose an exercise, locate divergences in different time frames, that meet all the named requirements: negative correlation (divergence) between the price and the indicator, peaks of highs and lows, and crossing the zero level.
See below if there is indeed a correction or a change in trend. And if you think there is a high success rate, you have learned a new strategy that you can develop to your liking and improve over time.
Success in trading comes with experience and practice, with improving a strategy and staying with it, even if it fails.