Divergences are what traders use when they are trying to spot a trend that is getting weaker. They want to see a trend that is getting weaker because they may believe that this is likely to indicate that there could be a reversal coming.
There are ten rules that you should take to heart when looking at trading divergences. If you are well-versed in these rules and use them yourself, then you should be able to keep yourself relatively safe from the worst types of things that can happen when trading incorrectly.
1 | Must Meet at Least One of These Four Simple Criteria
You will not act on any chart until you are absolutely certain that divergence is underway.
The only way to tell for sure is to see if any of the following exist:
- Higher high than the previous high
- Lower low than the previous low
- Double top
- Double bottom
If none of these are there, you aren’t trading a divergence.
2 | When Trading Divergences, Draw Lines From Tops and Bottoms
You need to draw lines between successive tops and bottoms. You need to see successive tops and bottoms before you can start to think about if you are spotting a divergence or not.
You will see one of the following: a flat high, higher high, flat low, or lower low.
Draw a line back in time from that high or low to the previous high or low. If you see bumps between the two major highs or lows, then you are not going to trade.
3 | Connect Successive Tops and Bottoms
Only If there are two swing highs established, then you are to connect the tops.
Two swings lows and you connect the bottoms.
Only connect those two successive highs or lows — and don’t ignore an additional, pesky swing high or low, when trading divergences.
4 | Focus Only on the Tops and Bottoms of Indicators
The only things that matter on your oscillators — RSI, Stochastic, or MACD — are tops and bottoms. Pay no attention to the two separate lines or the action between tops and bottoms.
5 | Practice Consistency in Time Spans on Swing Highs and Swing Lows
You need to draw lines on the swing highs and swing lows both on the chart itself and on the indicator that you are using. In other words, if you draw a line for highs on the price, you NEED TO draw highs on the indicator.
The same applies to lows.
The reason for this is that you need to establish consistency between the two figures. You can’t cheat your way into thinking that divergence exists when it doesn’t.
6 | Keep Price and Indicator Swings Aligned
There should be alignment between the swings that you see with the indicator and the chart itself. What you are looking for are divergences from the norm on your charts.
If you do happen to spot this, then you are perhaps where you need to be to trade divergence. Just make sure your lines are vertical to one another so you aren’t confusing yourself into thinking a divergence exists when it really doesn’t.
If you connect two highs on price, in a similar time span, you must connect the two highs on the indicator. The same applies to lows.
7 | Watch Your Slopes
The only way that divergence exists is if the slope of the line connecting the indicator’s tops and bottoms is different from the slope of the tops and bottoms on the chart itself. That is when there is divergence, and that is when a trend may be coming to an end.
8 | Don’t Chase It
There are times when you may have missed the moment to trade divergence. The worst thing that you can do is try to chase it. You feel bad that you missed out on the opportunity to trade divergence, and that is why you place your trade. You are very likely to lose money by chasing patterns like this. Avoid making this error.
9 | Look at Longer Time Frames
The strongest indicators of divergence appear in longer time frames.
If you are viewing a short time frame, you may find false signals galore. Try to look at the longer time frames to get a better idea of what is really going on with your trades.
10 | Focus on What Your Strategy Tells You to Do in Trading Divergences
Don’t worry about the moment-to-moment fluctuations in the market. Those are going to happen no matter what. What you need to focus on are the ways that your divergence trade is playing out.
If it is behaving as you expect it should, then you shouldn’t let yourself get shaken out of a winning trade.
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