Lets start with explanation of divergence
from another great
Buffy article that
appeared in Ensign Software Newsletter July 2002
by Buffy and NQ/ES Pals
Regular Divergence. Hidden Divergence. "What
a great tool, it really works!" "I see divergences all over the
place and would get chopped to pieces if I traded all the signals. Just
doesn't work for me!" These are comments and other variations of
them that are heard all the time in the NQ/ES Pals chat room. Hopefully, we can
clear up some of the confusion so you will be able to add regular and hidden
divergence successfully to your trading toolbox.
Divergence is a comparison of price to technical indicators.
It can also be a comparison to another symbol or spread between two symbols.
Divergence occurs when what you are comparing is moving in opposite directions.
Divergence can signal an up coming change in trend, a change of trend in
progress or that a trend should continue. A divergence signal suggests
watching for a trading opportunity in the direction of the signal.
Divergences may continue over many swing highs/lows so price action should
confirm your trade. This can be done in many ways, some of which are:
price making a higher high/low or lower high/low or price testing the last swing
high/low, price trading past high or low of previous bar, many of which will
correspond with the MACD histogram crossing zero.
Divergence trading can be used on many indicators --
Stochastic, MACD, RSI and CCI to name a few. As with most indicators,
divergence signals in a higher time frame (TF) are going to indicate a larger
move in price. The chart examples are going to be comparing price with the
Stochastic and MACD indicators. Each chart has the 50EMA (Blue), 200EMA
(Red), 9/3/3 Stochastic and the 7/10/5 MACD histogram on it. There are
many other Stochastic and MACD settings that also work for divergence signals.
Regular divergence (RD) is best used at the test of a
previous high or low, what most traders call a double or triple top/bottom.
It is not uncommon to see 3 or 4 higher highs in price in an up trend with 3 or
4 lower highs in the indicator or 3 or 4 lower lows in price in a downtrend with
3 or 4 higher lows in the indicator. This is called 3pt RD or 4 pt RD.
This is the indicator telling you with regular divergence that the trend is
getting weak and the potential for a change of trend is there and to trade
accordingly. To some traders, it might mean to tighten stops, while others
might prepare to exit the trade.
Hidden divergence (HD) is best used in trends for
continuation trades with the trend. A high percentage of hidden divergence
trades will move at least to the last swing high/low, thereby giving you a way
to calculate your risk/reward for the trade. If there isn't enough
points between the signal and the last swing high/low, then many traders will
usually pass on the trade. Another warning to pass on the trade signaled
by HD is having RD present for the last 3 highs in an up trend or last 3 lows in
a downtrend which is thereby signaling a possible change of trend (COT).
Many of you already use regular divergence in your trading.
When a fellow trader, NQoos, shared how he used
regular and hidden divergence in his trading and posted his charts as the
trading day developed, many traders in the NQ/ES Pals chat room became aware of
hidden divergence (HD). Regular divergence (RD) used with hidden
divergence (HD) can improve your percentage of winning trades. How much
depends on your style of trading.
As long as price is making higher highs and higher lows, that
time frame is considered to be in an up trend. When price is making lower
highs and lower lows, that time frame is considered to be in a downtrend.
The following two charts are an example of regular
divergence. Just because we see regular divergence when comparing two
highs in an up trend or on a comparison of two lows in a downtrend, it is not an
automatic trade. If the trend is strong enough, you may only get sideways
price action or a one or two bar retracement before the trend resumes.
Regular divergence can be a tool to answer the question of whether the trend is
gaining or losing momentum.
Regular divergence in an up trend (higher highs/higher lows)
compares the higher highs in price with the highs in the indicator. Note
that both Stochastic and MACD have a lower high while price has a higher
high...a signal the trend is getting weak.