Convergence and Divergence are leading indicators, which help identify trend reversals at the outset. The leading indicators are the ones which give signals about an event at the early stage. Since the signals are premature, there are considerable risks associated with it. Hence it becks the question- should you be trading divergence and convergence? But before answering the question, let us have a deep understanding of the CDC of trading- Convergence, Divergence and Congruence.
When the price of an instrument makes a new high or new low, and if the indicator, say RSI or MACD, doesn’t make a new high or new low, then the price and indicator are at a divergence.
What does it mean?
The trend has lost its momentum or at exhaustion. The reason being the indicators which display convergence and divergence are RSI, MACD, stochastic and ROC- all are momentum indicators. When these indicators fail to cross their previous highs, despite prices making a new high, the buyers (in an uptrend) are not taking it at the same pace which instigates the probability of profit booking or correction a notch up.
Trading Divergence – How and When?
When the price and indicator are at divergence, it is better to wait out for an indication of profit booking. A strong bearish candle or a bearish pinbar are the ideal ones to look out for.
The above chart illuminates the effect of divergence in the best way. The stochastic indicator and price diverge in their upside momentum. It signals the exhaustion of the trend. What follows is a significant correction move.
While comparing the highs of price and indicator for divergent set ups, it is essential to look out for lows. If a divergence- higher low in price and lower low in the indicator is formed(as marked in the chart), then the chances of successful divergent emanating enhances.
Detriments in Trading Divergence
- Trading divergence is based on the assumption that momentum and price action is not proportionate. The anti-proportionality results in profit booking. But profit booking need not be in the form of a corrective rally (bearish movement after an uptrend). There are consolidation movements in the form of sideways patterns like triangle patterns or flat waves (Elliot wave). The price action goes through time correction instead of price correction and then resume its trend when these types of pattern form.
- Also, the indicators like RSI and stochastic are oscillators- range between 0-100. Though they’re reliable indicators, they cannot evade the price momentum all the time, and they’re prone to diverge from the price action.
- Hence trading convergence and divergence is tricky. Many a time, profitable trend continuation setups tend to be overlooked on the lookout for divergence setups. Furthermore, the setup doesn’t provide an entry and exit point.
What do you see in the above chart? If you’re saying ‘Trading Divergence’ opportunities, you’re bound to regret later. It was a fantastic long-trade setup and prices making higher highs constantly. Hence, don’t miss out excellent trade opportunities on the lookout for divergences. You might’ve got odd profit trades here and there, but would’ve missed the monstrous rally.
A pair is at convergence if the indicator makes a higher high (uptrend) and the price action fails to back it up with a higher high. It happens in instances when there is momentum with the bulls (in an uptrend) to take the price higher. But despite the momentum, the price fails to cross the previous high which only means the momentum is false and likely to reverse the other way around.
Trading Convergence: How and When?
Like divergence, it is better to wait out for an impulse candle to kickstart the trend reversal. If a strong support or resistance coincides with it, it is the perfect set up. Convergence also tends to appear at the support and resistance a lot.
Here, the MACD indicator makes a new low, but the price of EUR/AUD is firmly held at the level of 1.56303. The strong support at that region proves to be a tougher nut to crack. The strong bullish candle formed, sets off the bulls to initiate long positions.
Detriments in Trading Convergence
The problem of trading divergence and convergence is that both are against the fundamentals of technical analysis – ‘the trend is deemed to continue always’. Yes, there are trend reversal setups. They do exist in technical analysis, but they are built around a compelling psychological notion too. Both convergence and divergence trading are based on a tiny filament of proportionality which leaves traders stranded high and dry during robust trend moves. The indicators then play the catch-up game. However, when these setups do occur in a strong support zone or resistance zone, it presents the opportunity of being an early bird.
If you were curious to know about congruence, from the point you read about CDC, disappointment awaits you here. Congruence is nothing but the indicator and price action are hand in glove. The usual scenario when price makes higher high and indicator also makes higher high (uptrend) is the congruence. So it is suffice to say, price action is at congruence usually and when they aren’t, they are either at divergence or convergence.
Convergence and Divergence: Conclusion
Trading divergence and convergence is the most riskiest way of trading. Because we never know when a divergent congrues. More number of times the trend is deemed to proceed than to reverse. Hence, it should be succinct and based on other factors too. It is safe to say, use convergence and divergence as ‘a’ factor in your set up but not ‘the’ factor.