Divergence is a tool that compares a currency pair’s price to an added indicator. Traders are looking for price to heading one direction, while the indicator another. In strong uptrends this can occur when price makes a higher high, but an indicator such as MACD makes a lower low. Normally this type of divergence in an uptrend can be a strong signal to reversal traders. Spotting divergence, can allow traders to move stops or modify their trading plan if a new trend emerges.
Below we can find the GBPAUD 4HR chart displaying traditional divergence. Since the GBPAUD is in an uptrend, we need to connect the two previous highs on our graph to form a trendline. Our first high was formed at 1.5727 on April 23rd; this point on the graph should be connected with the May 6th high at 1.5934. Viewing the trend line helps us establish that between these two points the GBPAUD did in fact form a new high.
The next step in identifying divergence necessitates we utilize a technical indicator. Below we have MACD using the defaulted 12,26,9 settings. To find divergence , we need to compare the MACD indicator for the same time frame. Moving down the graph, we can see MACD formed a high with a reading of .0069, nearly at the same time as price on April 24th. MACD proceeds to form a lower high, reaching a reading of .00646 on May 6th. By connecting the the two MACD points mentioned above, we have effectively created a downward sloping trendline on our indicator.
Putting both pieces of the puzzle together creates a usable signal for a variety of traders. Trend traders looking for higher highs in the previous uptrend, may consider managing an existing position. Swing traders will begin looking for a turn from current highs and breakout traders will look to spot breakouts to lower lows. Regardless of our chosen trading style, divergence should be a tool in every techincal traders tool box.
Using the analysis above, my preference is to catch a momentum shift lower on the GBPAUD. Entries can be placed using MACD or other mechanism 1.5850. Primary price targets for this pair reside at 1.550 for 300 pips of profit. Stops can be placed at 1.6000 for a clear 1:2 Risk/Reward profile.
Alternative scenarios include price retesting previous highs over 1.5940.
---Written by Walker England, Trading Instructor
To contact Walker, email WEngland@FXCM.com . Follow me on Twitter at @WEnglandFX.
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