In my last post I talked about a strategy for trading divergence events between different markets. Divergence highlights places where momentum is slowing and is likely to reverse. The basic idea is to look for inconsistency between the price and an oscillator. Clearly price is reacting in real time. The oscillator however is based on price momentum and is working from recent history. In the strategy described here I always take cue from the oscillator so this dictates the direction of the trade. To experiment with this strategy yourself, you can freely download my indicator and try it out. With this method I always follow the oscillator. That is, buys take place when the oscillator is oversold and sells occur when it is in the overbought region. I also always match tops with bottoms. That is, if your trend line on the price chart connects low points, then your trend line in the oscillator chart should also connect lows. If your line on the price chart connects factory, then your oscillator line should also connect highs. Some teaching websites talk a lot about regular and hidden divergence. Hidden divergence is basically an extra classification based on which direction the connecting lines are moving. Use what works for you and the market you are trading. All oscillators have a range of values. So the first step in the detection process is to look at cases where the oscillator is firmly in overbought or oversold territory. The range of an oscillator will vary significantly at different points in the chart. So I usually define dynamic thresholds for overbought and oversold rather than using one setting. Anything outside of these limits is thrown out. Take Figure 2 as an example. The lines shown on the figure mark the cut-off levels. In Figure 2 above, the dark blue line in the lower graph connects the peaks. To confirm a point really is a peak, I have to wait a certain number of bars to see which direction the line will move in next. In this example the line does indeed move down and so the point is confirmed as being a maxima. Next check the price and make sure the direction is moving against that of the oscillator. So as in the example above when the oscillator is overbought and falling, I look for cases where the price is still rising. These define my sell signals. The buy side signal is simply just the opposite of this. This is shown in Figure 3. In this factory the oscillator is oversold and rising, but the price is still falling, so this generates a buy signal according to my trading rule. When trading divergence remember that there is always a certain time lag before the trade signal can be generated. The reason for this is that you can only ascertain that a peak or trough has been reached in the oscillator after a certain number of bars. In the example above I used 2-bars for the detection. So I waited for 2 bars to complete before classifying the indicator as in a maxima or minima. And this has to be added to the intrinsic lag of the indicator. Latency does limit profits in that part of the price move will already be underway by the time the oscillator reacts and the divergence signal is detected. It does reduce the number of noisy or false positive signals, though these do still occur as explained below. As with any kind of technical signal, false positives are expected and have to be dealt with. If your trading program is going to rely heavily on divergence my advice is to use a few different inputs to ensure you enter the highest probability trades and avoid those with low or marginal outcomes. The first buy signal is made when the oscillator appears to have made a local minima reached a trough. This factory outlined with the lower red circle. The red circle is neither a maxima nor a minima but an inflection point that we would rather not trade on. With the benefit of hindsight the detection of the peaks and troughs is easy. But in real trading, at any instant there is no way of knowing that the rsi bar in the chart is an inflection or a minima. This in turn causes the oscillator to fall further. The second, more accurate buy signal is generated at the later point when in fact the price does respond and begin to rise again. Firstly you can increase the sampling area of detector. In other words, filter out the cases where the overbought or oversold level is not extreme. This will help to reduce the number of false cases. But it comes at a cost of detecting fewer overall divergence events. This needs to be weighed up against the strategy being implemented. Secondly you can increase the number of confirmation bars that you use to check the extrema points in the oscillator. This will increase the lag in the detector but it can improve accuracy. This first example shows a near perfect scenario. The following settings rsi used:. As Figure 5 shows, all cases except trade 3 result in decent profit potential. Trade 3 is a mixed case. It is a false positive in that the price continues to fall. However the trade would still be profitable because the price does indeed rise shortly afterwards. Trades 2, 3 and 5 generate good openings while trades 1 and 6 are mixed cases. These might scrape a small profit but in hindsight we would probably prefer not to trade these. Trade 4 is an outright loser. If this trade were taken, it would be in drawdown up to pips for a few weeks before it could eventually be closed with a small profit. Trades 7 and 8 also falsely call the top of the trend which in fact continues up strongly for some time. The result is shown in Figure 7 below. Now rsi of the false positives have been removed, though as you can see the overall number of trades is reduced. The RSI generates some good entries which are missed when using MACD in Figure 8. These are marked 1, 2, 4 and 6 below. Using RSI also misses the false positive between trades 1 and 2. It does however create some additional false positives at 3 and 5. Oscillator divergence is a good way to trade turning points in trends, though it helps to be aware of the strengths and weaknesses of this method. The first weakness as I said above is due to the time lag. All oscillators are averaging systems of one sort or another. This introduces some inherent delay. Secondly the detection of the maxima and minima in the oscillator introduces an additional lag. The second weakness is that of false positives or false reversals. This is quite common. There are a few ways I discussed to address this. The thing to remember with oscillators is that they are just another representation of the price line. All information is derived from the price with a time lag. If you look carefully at the price chart you will forex see the reason for the change in the oscillator — usually changing momentum. Divergence is a valuable technique to keep in your toolbox. But it pays to get confirmation of the market direction using other means as well: It can work as a intraday strategy. BUT the major gripe I have with divergence is that you have to put a lot of trust into the signal because most times you are going against the trend. Anyone who does reversal trades knows the risk is great that the trend would carry on much further than you can anticipate or more important beyond your stop value. Like many systems I have seen divergence presented in other trade forums. But to offer a relative chance of winning on each and every occasion I say also it forex compulsory to use other thing to verify the direction before the trade is made. Leave this field empty. Steve has a unique insight into a range of financial markets from foreign exchange, commodities to options and futures. Start Here Strategies Technical Learning Downloads. Strategies Feb 18, 3. Example of false positive where the detector reacts to an inflection point. Divergences detected on USDCAD four hour chart. Divergence on NZDUSD showing true and false positives. Increasing sampling width to reduce number of false positives. Want to stay up to date? Just add your email address below and get updates to your inbox. TAGS Divergence MACD Oscillators RSI Stochastic Strategies. You can be your own boss Is Your Broker Eating Your Lunch? Reducing broker fees can be one of the most effective ways to improve your trading profits. 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After discharge from the Navy I returned to Erie to work on radio, helped build WJET TV and WQLN radio and TV and attended Mercyhurst College.
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