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Trend trading is fine when the trends are strong. What do you do when they’re weak? How do you even know?

The Hidden Truth Is Revealed

Oscillators are among my favorite tools. It doesn’t matter which one, they all pretty much do the same thing but in different ways. For trend traders they are invaluable giving signals for entry in a manner that is easy to follow and simple to set rules for. What I really love about them is that they are like an X-ray into the market. They can tell you what is really going on behind that rally or sell-off. Sometimes there is strength and sometimes not.

divergence trading with trend
The example of divergence

The standard method for using an oscillator such as stochastic, MACD or RSI is for trend following. Trend can be determined in a number of ways including multiple time frame analysis, trend lines and moving averages. Once trend is determined signals are filtered based on that direction effectively weeding out about 50% of all signals produced. The strength of the trend is measured by convergence. If the oscillator is moving up alongside prices it is said to be in convergence or agreement with price action. If price action creates a peak and the oscillator makes peaks in tandem, and the both make another peak higher than the first that is also said to be convergent. Prices are gaining strength and so is the oscillator; this is a sign of continuation within the market.

Read also: Financial Market Momentum Like Your Advantage

  • Oscillators give signals irrespective of trend, it is our duty as traders to weed out false, bad and lower probability signals.

A divergence is when price action creates a new higher, or lower, peak and the oscillator peak does not match. In the case of an uptrend prices will make a higher peak but the indicator will make a lower peak. In the case of a downtrend prices will make a lower peak but the oscillator will make a higher one. This is an indication of underlying weakness within the market, the slow death of the trend in question and the possibility of reversal.

The caveat for traders is that divergences are not always a strong signal. An indicator can be in divergence within a trend for some time before correction or reversal takes place. This is why divergence trading requires additional confirmation, above and beyond what you might seek with a trend following signal.

For example, prices may have bounced from support within a greater trading range. On its way higher the bounce creates one, and then another peak within the near term uptrend with divergence showing in the indicators. This divergence suggests that 1) the rally is weak and not likely to extend beyond resistance and 2) that bearish candle signals and/or tests of resistance are likely points of reversal. With this in mind when a divergence appears on your chart look for likely points of reversal within the trend you are analyzing. Then watch those points for secondary confirmations such as candle signals or other price patterns (head and shoulders, double top/bottom).

  • Near and short term lines of support/resistance, those found on chart/candle settings less than 1 hours, will be less likely to form major reversals than those found on longer term charts like 1, 2 or 4 hours.

Look at the chart below.

Divergence

It is a one hour chart of Litecoin and shows the cryptocurrency completing a reversal at major support. This support line was established in the wake of the China Sell-Off and confirmed by divergence in MACD. We can see that the coin make a new low with MACD convergent and then makes another new low with MACD divergent. The divergence occurs as the coin hits the support target and is then followed by a bounce and bullish candle confirming the move. While the divergence indicated the possibility of reversal the bullish candle confirms it.

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NOTE: This article is not an investment advice. Any references to historical price movements or levels is informational and based on external analysis and we do not warranty that any such movements or levels are likely to reoccur in the future

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