Divergences are most commonly used in forex to predict price reversals in both up and down trending markets. In a nutshell, divergences occur when the currency pair price and the technical indicator (MACD, RSI, STOCH,…) trade in opposite directions.
Normally, price should always trade in agreement with the supporting TA indicator, both up or down. The big advantage of trading divergences is that they offer you low risk to reward trades since you’re ready to buy currencies near a bottom or sell near the top.
A. Forex Bullish Divergence Trading
Bullish divergences occur where the currency price trades lower while indicator readings go higher. Bullish divergences suggest a likely move to the upside. Let’s take a look at bullish divergence and how to profit from this tool. Below is a 4 hour chart of GBP/USD.
The GBP/USD make lower lows while the MACD indicator make higher lows, thus creating bullish divergence in the chart above. We could enter a long position at 1.5733 with stop loss 1 pip below the supporting trend line at 1.5646. The long trade was confirmed by the hammer candlestick pattern.
B. Forex Bearish Divergence Trading
As opposed to bullish divergences, bearish divergences occur where the currency price trades higher while indicator readings move lower. Bearish divergences suggest a likely move to the downside. Let’s take a look at an example. Below is a daily chart of EUR/USD.
In the chart above, we could enter a short position at 1.4035 with stop loss at 1.4285 for a short ride towards 1.3570 (so far).
The trade was confirmed by a bearish candlestick pattern.
Another example: EUR/USD 1 Min Chart
As shown in the chart above, trading divergences can be used by forex scalpers as well. The short trade was confirmed by a small triangle pattern that appeared on the EUR/USD 1 min chart.