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The term divergence is often used when talking about technical analysis and indicators. Divergence is an occasion when the asset price moves in one direction, while the indicator shows the opposite signal. The divergence can confuse the trader, but more experienced traders know it can be useful and can sometimes serve as a signal in itself. Let’s take a look at this phenomenon, explore why it is happening and how it could potentially be used to the trader’s benefit.
When does this happen?
This term is used when the price moves in the opposite direction to that of the oscillator. This can happen with any oscillator, regardless of the type used by the trader. The most popular oscillators are RSI, MACD and Stochastic – and they work well, but there is no indicator that could guarantee 100% accurate signals and that is why it is important to understand the concept of divergence. .
Divergence occurs when the asset and the indicator show a difference in movement. There can be positive divergence and negative divergence.
A positive divergence occurs when the price of the asset falls, while the indicator shows a higher value. This can mean that there is a possibility that the price of the asset will rise. A negative divergence occurs when the asset hits a new high, but the indicator shows a lower high. In this case, the price of the asset may go down.
Example of positive divergence on the EUR USD chart
In the positive divergence example above, we notice that the price continues to fall and forms a lower low, while the RSI shows the opposite. This shows that the downtrend for EUR USD is losing strength.
The opposite of divergence is convergence – when the indicator and the asset move in the same direction and the indicator confirms the price movement. Ideally, this is what the trader wants, as it confirms the strength of the trend. When the asset price and the oscillator move next to each other, it is a sign of the continuation of the market and normal conditions therein.
What does the discrepancy tell you?
The divergence may indicate that the current price trend is weakening and may soon be reversed. It indicates the lack of dynamism of the asset. The divergence can be a sign of a potential opportunity for a new trade or it can signal the need to set a stop loss level for a trade. In some cases, when a positive divergence occurs, it can be a sign that the trend is reversing upward and the price will soon rise. A negative divergence, on the other hand, may mean that the uptrend is losing strength and the price may soon come down.
However, it is important to understand that one should not rely on the discrepancy alone. While it may indicate the possibility of a trend reversal, it does not provide timely signals. The divergence can last for a long time and if the price does not go in the indicated direction it can lead to big losses.
Divergence does not always mean a trend reversal, it is simply a reflection of the strength or weakness of the trend. Operators should therefore implement all the necessary risk management tools and check any signals they may receive from an oscillator. It's also important to remember that divergences are not very common, and they don't happen every time a trend reverses. This is why it can take time to master these types of signals.
Source: IQOption blog (blog.iqoption.com) 2020-07-28 14:18:18
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