How to Incorporate Divergences in Your Trading Strategy

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Every investor knows the important trading principle of buying low and selling high. However, it isn’t just the stock price or the fundamental story about the company you are investing in that can indicate the best time to buy and sell. It is often helpful to look at the charts and spot a price breakout before it actually happens. This can be done with the help of oscillators that can show divergences. These divergences may be bearish or bullish, but more importantly, they point to the next dramatic movement of a stock, be it upwards or downwards. Staying aware of stock movement, trends and oscillators can help you execute profitable trades.

A divergence is when the price of a stock is moving in a different direction from an oscillator. For instance, if the stock price is moving up but the oscillator shows that it is actually starting to make lower lows rather than higher highs, that may be a sign to take action. There are many different types of oscillators. Among the most popular are the RSI, the Relative Strength Indicator, or the MFI, Money Flow Index. You can also use Stochastic RSI, which measures the RSI itself. These can be measured against the movement of the stock price to help detect divergences.

There are four main kinds of divergences: bullish divergence, bearish divergence, hidden bullish divergence and hidden bearish divergence. The bearish divergence comes at the end of a downtrend. The stock price will keep going lower, but the RSI will indicate it is making higher lows. This points to the possibility that the trend will reverse and the stock price will go up. A bearish divergence happens at the end of a positive trend. The stock price keeps going up but the RSI shows it is making lower highs. The hidden versions of both the bearish and bullish divergences occur within the trend. This means that there has been a detectable divergence, but the trend went back to “normal.” However, the disruptions created by these divergences may indicate that there will be future divergences or a complete reversal of the trend.

Given the common occurrence of hidden divergences after which the trend continues, it is important not to undertake knee-jerk trades the moment you see a divergence. A common mistake many beginner traders make is that they may be tempted to react too quickly. Instead, look for these divergences as a guide and be more cautious if you have seen only one divergence. If there have been several, it is more likely that the stock will break out. Once you have observed the divergence from looking at the charts and the oscillators daily, watch for an uptick in the stock or a decline before you execute your trade. It is also important to consider that divergences can last a long time. Before making a trade within a longer-term divergence, look at the trading volume and how long the divergence has lasted. You might realize that you are in a trend within a trend if there is a long-lasting divergence, so you may decide to skip it or wait for a pullback and buy.

Price action tells only part of the story when it comes to trading stocks. An efficient approach to trading involves paying attention to oscillators, such as the RSI, the Stochastic RSI, and trends. Effective trading requires a combination of prudence and patience. Taking the time to get the full picture of the story by spotting divergences on a chart is the best way to make informed decisions and profitable trades.

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About Author

Adinah Brown is a professional writer who has worked in a wide range of industry settings, including corporate industry, government and non-government organizations. Within many of these positions, Adinah has provided skilled marketing and advertising services and is currently the Content Manager at Leverate..

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