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Candlesticks and Divergence What is Divergence? Interpreting Divergence Misinterpreting Divergence How to use MACD, Stochastics and RSI with Divergence Hidden Divergence www.candlecharts.com/free-education
What is Divergence? Divergence in trading charts is when price action differs from the action of various indicators, e.g., the MACD, stochastic oscillator, RSI, etc when the price of an asset and an indicator, index or other related asset move in opposite directions. The idea is that divergence is showing decreased momentum that isn t reflected in price yet, which could be an early indicator of a reversal. www.candlecharts.com/free-education
Interpreting Divergence In technical analysis divergence is considered to be positive or negative. Either direction is a signal of a major shift in the direction of the price. Positive divergence occurs when the price of a security makes a new low while the indicator starts to climb. Negative divergence happens when the price of the security makes a new high, but the indicator fails to do the same and instead closes lower than the previous high. www.candlecharts.com/free-education
Interpreting Divergence We will be looking for periods where price is making lower lows (or double bottoms) while, say the stochastic oscillator is making higher lows (bullish stochastic divergence), or where price is making higher highs while the stochastic oscillator is making lower highs (bearish stochastic divergence). www.candlecharts.com/free-education
Interpreting Divergence We often trade MACD divergence (which is one of the most powerful forms of divergence) as well. We don t trade RSI divergence as often, but it can be just as powerful, as long as you have a trading strategy that utilizes it properly. www.candlecharts.com/free-education
Misinterpreting Divergence Trading signals derived from divergence that are based on oscillator indicators can be difficult to read, and they are sometimes misleading. When the market is in a strong trend in either direction, oscillators do not function well. Any signs of divergence during a strong trend would be ambiguous at best. Divergence is best suited for confirming market moves and should be used in conjunction with other technical. www.candlecharts.com/free-education
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How To Trade MACD, Stochastic, and RSI Divergence In the following charts, we will see some good examples of how to trade divergence between the MACD, Stochastics, and RSI indicators and price. The key, and what separates the pros from the average losing trader, is how the pros combine divergence strategies with other trading strategies. You can use many different kinds of supporting trading signals when you trade divergence patterns, but for the purposes of this Special Topic, we ll be combining price action signals with our divergence signals to get high-probability entries. www.candlecharts.com/free-education
www.candlecharts.com/free-education Harami NOTE: A shortcoming to trading MACD divergence is a ranging market. During a ranging market, the MACD and signal line will cross the zero line frequently. You should avoid trading divergence, and possibly trading altogether, during these periods. Engulfing
www.candlecharts.com/free-education A Bullish Piercing pattern formed at the lower low in price while the MACD line made a double bottom (slightly higher low). Next, price made a double top with Bearish DCC and Engulfing while the histogram made lower highs. Bearish Engulfing Dark Cloud Cover Piercing
www.candlecharts.com/free-education Next, price made three consecutive highs approaching Pivot resistance Bearish Shooting Star while the histogram made lower highs. Shooting Star
www.candlecharts.com/free-education A Bullish Engulfing pattern formed at the lower low in price while the MACD histogram and line made a higher lows. **This gives an early indication that the bearish trend is ending and that a change in trend is forming. Engulfing
www.candlecharts.com/free-education Starting from the left, you can see some traditional MACD histogram divergence. The histogram is making higher lows or double bottoms, while price is making lower lows. Using price action as our confirming entry signal, we would have skipped the first example of bullish divergence, because there were no bullish candlestick signals to confirm our entry. No Signal Weak Signal Hammer, IH, Piercing BUY Signal
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How To Trade MACD, Stochastic, and RSI Divergence Note: The stochastic indicators pictured previously are set to 21/3/3; 13/3/3 and 8/3/3. I prefer these settings when I m using this oscillator to trade stochastic divergence. www.candlecharts.com/free-education
How To Trade MACD, Stochastic, and RSI Divergence RSI Divergence: Learning how to trade RSI divergence can be tricky. You ll notice that the RSI line chops up and down quite a bit, so it s not enough to base your RSI divergence trading on just any RSI highs or lows. You have to make sure that the highs or lows that you re basing your RSI divergence off of correspond to distinguishable highs or lows in price. The same is true when you trade MACD, stochastic, or RSI divergence, but the problem is more pronounced with the RSI. www.candlecharts.com/free-education
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Hidden Divergence vs Regular Divergence What You Should Know The difference between hidden divergence and regular divergence is that hidden divergence is drawn off of the highs of price and the indicator in a downtrend. Similarly, it s drawn off of the lows of price and the indicator in an uptrend. This is the opposite of regular divergence. Hidden divergence also signals a possible trend continuation. Regular divergence signals a possible trend reversal. Both can be powerful entry signals. The next charts show examples of hidden divergences. www.candlecharts.com/free-education
Here are some examples of hidden MACD divergence. Hidden divergence is measured off of the lows of price and the indicator during an uptrend, and off of the highs of price and the indicator during a downtrend (the opposite of regular divergence). www.candlecharts.com/free-education
Starting from the left, price made higher lows while the histogram made lower lows. Next, price made higher lows while the histogram once again made a lower lows. These are both examples of bullish hidden divergence. www.candlecharts.com/free-education
Here s an example of bearish hidden stochastic divergence. Price made a lower high while the stochastic oscillator made a higher high. *Remember that, for hidden divergence, we measure off of the highs of price and the indicator in a downtrend. www.candlecharts.com/free-education
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In this chart, you can see an example of bearish hidden RSI divergence. Price made a lower high while the RSI made a higher high. A bearish Harami pattern formed at the second high, confirming our hidden divergence pattern. www.candlecharts.com/free-education
Hidden Divergence vs Regular Divergence Hidden divergence is a sign of trend continuation, while regular divergence is a sign of trend reversal. The idea is that regular divergence shows momentum leaving the trend, which could be an early sign of a reversal. Hidden divergence shows momentum coming into the current trend, which makes a continuation more likely. www.candlecharts.com/free-education
Hidden Divergence vs Regular Divergence Tips for Trading Hidden Divergence To greatly increase your success rate with divergence trading, combine your various divergence patterns with other entry triggers. Always look for candlestick patterns in combination with hidden divergence. www.candlecharts.com/free-education
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www.candlecharts.com/free-education Regular Divergence Hidden Divergence
www.candlecharts.com/free-education Hidden Divergence Regular Divergence
www.candlecharts.com/free-education Hidden Divergence Hidden Divergence
Regular Divergence www.candlecharts.com/free-education
www.candlecharts.com/free-education Hidden Divergence Reversal at 50% retracement
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How To Trade MACD, Stochastic, and RSI Divergence Final Thoughts: You may or may not have noticed that all of these divergence examples are from about the same time period. Some traders like to stack these three indicators on their charts. When two or more of them are showing divergence at the same time, they can reveal some very high-probability trading entries. Learning how to trade divergence is powerful, but divergence signals should only be treated as indications of possible trading opportunities not as buy or sell signals in and of themselves. The pros always combine other trading signals with divergence to gain an edge in the market. www.candlecharts.com/free-education
How To Trade MACD, Stochastic, and RSI Divergence Divergence trading isn t fool proof. This technique does not work well in range bound markets, and on its own divergence will often give you many false positives. This is especially true when the market is trending strongly in one direction for an extended period of time. Successful trading is the act making better trading decisions than about 95% of other traders. That takes a profitable trading system, great psychological discipline, and impeccable money management. Learning how to trade divergence on the MACD, stochastic, or RSI like a pro might just give you the edge you need over typical losing traders. www.candlecharts.com/free-education
How To Trade MACD, Stochastic, and RSI Divergence It is important to only trade divergence signals that occur during periods of distinguishable higher highs or lower lows in price. Strong, parabolic moves in price, in one direction or another, with little to no retracement, do not make good divergence signals. Are you trading divergence correctly? Hopefully this Special Topic will shed some light on any mistakes you might be making with this popular trading technique. Like anything else in trading, you can t expect to be an expert divergence trader over night. Be sure to do plenty of backtesting and demo trading before trying any new trading strategy in your live account. www.candlecharts.com/free-education
Use candles to Confirm Key Levels Candlesticks and Divergence