Home / Indicators / How To Trade A Divergence – A Step By Step Trading Guide

How To Trade A Divergence – A Step By Step Trading Guide

Divergences are one of my favorite trading concepts because they offer very reliable high-quality trading signals. Although indicators are somewhat lagging – just like price action is lagging too – when it comes to divergences, this lagging feature is actually going to help us find better and more reliable trade entries as we will see below. Divergences can not only be used by reversal traders, but also trend-following traders can use divergences to time their exits. In my own trading strategy, divergences are a big part.

 

What is a divergence?

Let’s start with the most obvious question and explore what a divergence really is and what it tells you about price. You’d be surprised how many people get this wrong already.

A divergence forms on your chart when price makes a higher high, but the indicator you are using makes a lower high. When your indicator and price action are out of sync it means that “something” is happening on your charts that requires your attention and it’s not as obvious by just looking at your price charts.

Basically, a divergence exists when your indicator does not “agree” with price action. Granted, this is very basic and we will not explore more advanced divergence concepts and see how to trade them, but it’s important to build a solid foundation.

divergence-101
Bearish and bullish divergence. Price and indicator are out of sync. Divergence foreshadows reversal.

 

A RSI divergence

#1 Revisiting the RSI

Divergences work on all indicators, but my favorite by far is the RSI (Relative Strength Index). The RSI compares the average gain and the average loss over a certain period. So for example, if your RSI is set to 14, it compares the bullish candles and the bearish candles over the past 14 candles. When the RSI value is low, it means that there were more and stronger bearish candles than bullish candles over the past 14 candles; and when the RSI is high it means that there were more and larger bullish candles over the past 14 candles.

 

#2 When does a RSI divergence form?

Understanding when your indicator is high or low is important when it comes to interpreting divergences and I generally encourage traders to look beyond the squiggly lines of their indicators to explore what it really does.

During trends, you can use the RSI the compare the individual trend waves and so get a feeling for the strength of the trend. Here are the three scenarios and the screenshot below shows every single one:

(2) Typically, the RSI makes higher highs during a healthy and strong bullish trends. This means that there were more and larger bullish candles in the most recent trend wave than there were compared to the previous wave.

(1) When the RSI makes similar highs during an uptrend it means that the momentum of the trend is unchanged. When the RSI makes an equal high high, it does not qualify as a divergence because it just means that the strength of the uptrend is still up and stable.

(3) When you see that price is making a higher high during a bullish trend, but your RSI makes a lower high, it means that the most recent bullish candles were not as strong as previous price action and that the trend is losing momentum. This is what we call a divergence and in the screenshot below, the divergence signaled the end of the uptrend and it makes a downtrend possible.

What-is-a-divergence

 

#3 Conventional technical analysis is flawed

Classic technical analysis tells us that a trend exists when price makes a higher high – but like too often, conventional wisdom is seldom right and usually simplifies things too much. A trader who only relies on highs and lows for his price analysis often misses important clues and does not fully understand market dynamics. Even though a trend could look “healthy” at first glance (higher highs and higher lows), it might be losing momentum at the same time.

Spotting a divergence on your momentum indicator, thus, tells you that the dynamics in the trend are shifting and that, although it could still look like a real trend, a potential end of the trend could be near.

 

How to trade a divergence – the optimal entry

I am a pure reversal trader and counter trend trades after divergences are my bread and butter trades. Over hundreds of trades I have confirmed with my records that by adding a moving average to my entry criteria, I can enhance the quality of my trades significantly.

A divergence does not always lead to a strong reversal and often price just enters a sideways consolidation after a divergence. Keep in mind that a divergence just signals a loss in momentum, but does not necessarily signal a complete trend shift.

To avoid trade entries that don’t go anywhere, I highly suggest adding a 20-period moving average to your charts. When you then see a divergence, you would only enter a trade if price also breaks the moving average afterward. Such a scenario is much more likely to lead to a real trend reversal and you can avoid a lot of market tops where price just hovers sideways.

The screenshot below shows two divergences during the ongoing uptrend, but neither stopped the trend. However, price never broke the moving average (in white) and the moving average criteria would have kept the trader out of losing trades.

EMA_hold

 

This is where the lagging nature of indicators actually helps us traders. When trading reversals, most traders try to predict a reversal before it happens and they sell during uptrends or buy during sell-offs. A divergence as a signal forces you to wait until price has already started reversing. I call it “my insurance” because it keeps me out of a lot of trouble. Together with the moving average rule, you completely avoid predicting moves and only trade strong and confirmed reversals.

The screenshot below shows a great example. We saw a multi-divergence, but only after price broke the moving average, it gave us the signal to enter short.

EMA_break

 

Tip: Location

Location is a universal concept in trading and regardless of your trading system, adding the filter of location can usually always enhance the quality of your signals and trades. Instead of taking trades just based on a divergence signal, you’d wait for price to move into a previous support/resistance zone and only then look for divergences and trend shifts to time entries.

The screenshot below is a great example: On the left side you see an uptrend with two divergences. However, the first one completely failed and the second one resulted in a massive winner. What was the difference? When we take a look at the higher time frame on the right we see that the first divergences happened in the middle of nowhere and the second divergence formed at a very important resistance level (yellow line and yellow arrow). As a trader, you first identify your support/resistance zones and then let price come to you. Such an approach will impact your performance in a big way.

location

 

Divergences are a powerful trading concept and the trader who understands how to trade divergences in the right market context with the correct signals can create a robust method and effective way of looking at price.

If you want to learn more about divergences and how to trade reversals, you can take a look at our trading courses where you will learn our whole strategy step by step.

 

 

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48 comments

  1. Great article. I don’t use the 20-MA but I will consider it. Where do you put your stop in your entries?

  2. Hi Rolf,

    Thanks for your article. Very helpful! Do we have to wait until the candle close below/above the 20 EMA for us to take the trade or just enter right away when we see the break occurs?

    Thank you again,
    King

  3. Hi Rolf,

    thank you for very informativne article. Can you pls tell us what is your winning rate and average risk:reward ratio of your divergence reversal trade? I’m a main trend following swing trader, but I’m thinking of incorporating your reversal trading style to earn some bucks out of retracement waves as well. It’s very hard for me to wait for price to retrace 50 – 61.8 % before taking positions.

  4. Thank you for a great article. Do you have examples where this apprach can be used with other indicator tools like DMI or MACD

  5. Excellent piece. Thanks for sharing your wisdom and experiences.

  6. This post was really awesome!

    I would like to ask though, do you always set your RSI at 14 days or do you change it on different situations?

    Thanks

    • Hello Marcos,

      thanks for the kind words. I leave the 14 period settings. I trade mostly on the 4H timeframe so the 14 periods capture roughly 2.5 days which is sufficient to analyze swings and trend waves. Usually, you don’t need the indicator to know it’s a divergence, but it’s an additional and objective confirmation.

      Rolf

      • Hi Rolf,

        Your inputs are awesome! I have started reading it all.

        It caught my attention lately this area “divergence”. You have reply to Marcos that even without the RSI indicator you can identify that it is divergence. As we all know indicator have lag time.

        As an additional to your great piece- would you be so kind to tell us how to spot divergence before the RSI confirm it. Thanks.

  7. This is magic, had I knew this at the beginning of my trading career I would have been far But will still make it worthwhile

    *When your indicator and price action are out of sync it means that “something” is happening on your charts that requires your attention*

    You changed my trading game for the best

  8. When do you exit to take profit? Or how do you determine when to exit?

  9. Hello Rolf. Thanks for sharing this valuable piece of information. I’m not sure if you answered this question already, but how do you determine an exit strategy/know when the “play is over”? Is there a way that you can know when the counter trend is over?

    thanks again!
    -john

    • Hello John,

      in a nutshell, I trail my stop along the 20 SMA and/or based on support/resistance levels. I will make a detailed article on trade exits, though, soon.

      Rolf

  10. Hi Rolf,

    Thanks a lot for such a wondorful article, however in the examples above you have only considered the best set up for divergences when the RSI is ONLY above 70 for bulish trends. Is this is a necessity for the best set ups or can it happen without it under your observations?

    Cheers
    Ram

  11. sarath udaya kumara Mahakumburegedara

    Factors are described very simply way.very much understandable . Thanks

  12. Like how you break it down Rolf. Thank you.

  13. hy man, this is what i was looking 4,i know there is nothing authentic in reversal but this is the closest one. thanks

  14. Hi Rolf,

    Lets say after I spotted the divergence signal and open a trade after price action confirmation, do I need to come back and check on the chart again for any new divergence signals again? It would have new divergence that affect our trading plan?

    Thx

    • Hello,

      what do you mean with new divergence signal? Can you please attach a chart example with a tradingview link so that I can get a better idea.

      Rolf

  15. You are a great teacher, Please divergence that forms below 70 for bearish signal and above 30 for bullish signal, are they good for trading?

  16. hello rolf, thank for a great article, i read two different divergence while trading rsi, called regular divergence and an unknown concept called hidden divergences, can you pls explain the term hidden divergence and if you can make a video on it
    thanks

    • Hello,

      I don’t think hidden divergences are really helpful. Stick to the common divergences – they are very good if the context around them agrees.

      Rolf

  17. Best I have ever read, really clear explanations and so well explained, greatly appreciated. Many thanks. John.

  18. Rolf,

    Just two queries please:

    1. Do you use the 20 SMA or 20 EMA?

    2. Does the candle have to penetrate the moving average or close the other side of the MA?

    Many thanks,

    John.

  19. hi Rolf….u r really awesome.how delegated u r ever seen before.i would like to know where u will use our SL ?

  20. Hello Sir,

    First of all thank you for sharing such a great technique. I have some doubts. I am an Intraday trader and use time frame 1 minutes and 5 minutes candles. I am using RSI (9) and (14). I get more divergence signals in 1 minute candles (60-70% accuracy) than 5 minutes. So please guide which time frame & RSI get more accuracy in intraday. Also please tell any other indicator to support the RSI other than Moving Average to get more accuracy.

    • Hello Vinu,

      thanks for reading our article. I use anything from the Daily, 4H to 1H timeframe for my divergence trading. But it certainly applies to lower timeframes as well.

      Rolf

  21. Hello sir
    Beautifully explained
    Thanks

  22. Hi , very interesting article. I have question regarding the use of MA 20 – Which movieng averadge simple or exponential / or it does not matter?

    thank you

    Ondrej

  23. bro how to use 50 sma or ema ? 😀

  24. Hi Rolf,

    A wonderful article which explains RSI in detail. Thank you so much. One request, can you write one article or make a video to explain when to Exit.

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