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Divergence: The Other Side of The Oscillator

Divergence: The Other Side of The Oscillator

2011-08-04 01:07:00
James B. Stanley,

Divergence: The other side of the Oscillator

If you ask 10 traders their favorite indicator, you’re likely to get at least 7 different answers. Indicators, and the use of which, can greatly differ from trader-to-trader depending on market approach, strategies, and maybe even more importantly – goals.

One commonality amongst many traders using Oscillators (such as MACD, RSI, CCI, Stochastics, etc) is the rampant joy of locating divergence. Divergence is a case in which we receive a higher-high on price, yet the Oscillator fails to make a higher high. Perhaps a picture using one of the more common Oscillators, RSI, would explain better:

Divergence_the_other_side_body_Picture_1.png, Divergence: The Other Side of The Oscillator

As you can see, after price establishes a new high – the trader can observe RSI making a ‘Lower-High.’ This denotes to the trader that Divergence is taking place. This is generally emblematic of a previous trend beginning to soften.

For example, notice in the above chart, Divergence takes place with RSI after an extended up-trend. Let’s take another look at the same setup as above:

Divergence_the_other_side_body_Picture_2.png, Divergence: The Other Side of The Oscillator

Notice the extended up-trend that had taken place before the Divergence occurred. The congestion taking place after the first circled high and before the second is what has helped create the Divergence with RSI.

The congestion of price between the two circled highs indicates that the up-trend is softening, and perhaps – signaling that a reversal opportunity may be available in the not-too-distant future. This is one of the few tools that traders have available to identify reversal opportunities, and that is why so many traders get excited when spotting this facet of RSI (or MACD, CCI, Stochastics, etc).

Not only does Divergence give the trader a potential trade idea; these situations can also offer a compelling risk:reward opportunity.

The trader can look to place a stop slightly above the ‘Higher-High,’ and if the stop gets hit – the trader knows that the up-trend is, in fact, continuing. This way the trader can potentially prevent themselves from being over-exposed on the trade.

Divergence_the_other_side_body_Picture_3.png, Divergence: The Other Side of The Oscillator

If the reversal does take place, the trader can potentially reap a large reward relative to their initial risk. The chart below illustrates what happened in the example above. As you can see, this case of Divergence on RSI helped spot the reversal before it actually took place:

Divergence_the_other_side_body_Picture_4.png, Divergence: The Other Side of The Oscillator

With any oscillator, whether or not divergence is present, keep in mind: Oscillators can stay Oversold, or Overbought for extended periods of time. Money Management is a critical element for the traders’ approach when employing such methods.

If you’d like to be notified of upcoming articles, please email me at instructor@dailyfx.com, and in the subject line, type in ‘notification.’

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