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PR11 - Five rules to trade divergences effectively

"Divergences are leading indicators which can signal a potential correction in price. It is due to this feature that divergence based trading methods are so popular. Another fact is that divergences are formed in the context of a trend, making it popular among trend traders as well. But divergences, simple as they sound are not always that easy to trade. You will make quite a few mistakes initially. The biggest hurdle is in training your eye to spot the divergences that are formed. Even after mastering this, you need a lot of practice time to trade effectively with divergences. Remember that divergence based trading is not a mechanical trading system. There is a bit of discretion involved. This is where the above five rules apply. You can easily lose money trading divergences, just as easily how you can make money with this method. In this article, we introduce you to the concept of divergence and some traps to avoid."

In the previous article, we covered the basics of divergences and the different types of divergences that you encounter. Divergences, as you know are leading indicators. They potentially signal a correction in the price.

Thus, they can be very effective in predicting the short term direction of the markets. However, trading divergences is not as simple as following the rules and expecting to make money. Due to the irrationality of the markets, a bit of discretion is required.

As a beginner, you will firstly have to spend a lot of time to train your eye to spot the divergences. While there are many automated trading indicators that can spot divergence for you, the best way is to look for divergences manually.

This will give you more confidence in the markets and also helps you to build the market context which is quite important. There are many traders, who despite years of practicing trading with divergence continue to lose money. But there are some simple tricks to follow that can help you avoid losing money.

Rule #1: Support and Resistance

Divergences, are nothing but price reacting to support and resistance levels. Therefore, before you get excited about divergences, bear in mind that price must still obey the rules of support and resistance.

One of the best ways to identify this is to begin with plotting the support and resistance levels on your chart. Following this, you can then watch for divergences to form. For example, if you see a bearish divergence forming near a resistance level, you can expect the probability for a correction to be higher.

Likewise, trading a hidden bullish divergence near a support level will increase more validity to the divergence rather than trading that signal in isolation.

Rule #2: Always stay patient

One of the biggest mistake traders make when trading with divergence is that they tend to jump into the trade. This is done for the fear of missing our (also known as FOMO) or due to greed.

The basic defining logic behind this is that traders expect to make some extra profits before the divergence is already confirmed. This is of course a bad idea. Sometimes, you can witness multiple divergences. Thus, taking a premature position in the markets can lead to quite a huge bit of losses over time.

It is important that traders remain patient and wait for price to confirm the divergence before you can jump into the trade. While you might not get an edge compared to others, you will still be trading on the safe side.

Rule #3: Patterns to look for

Divergence patterns are most likely to form when price is making new highs. However, you can look for chart patterns such as double tops or double bottoms (even triple tops/bottoms) to use divergence based methods.

Chart patterns such as ascending and descending triangles, bullish and bearish flag patterns and so on can indicate a high probability of divergences being formed. Using the chart patterns and the divergence that is formed, you can increase the effectiveness of your trading.

Rule #4: Candlestick patterns

Candlestick patterns are powerful and dynamic patterns that convey a lot of market information. Therefore, using them when trading divergences can greatly improve the chances of your success.

It is not just single reversal candlestick patterns but also multiple candlestick patterns that can help to increase the probability of success for divergence based trades. You can also make use of other chart types such as Heiken Ashi charts which depict trend in a more visually appealing way.

This way you can watch as the price starts to correct and retrace its previous trend.

Rule #5: Watch the trend

It is pointless to trade divergences if you do not pay attention to the trend. Having the context of trend is important because divergences and trends go hand in hand. Even if you are a short term trader to whom the trend doesn’t matter, it pays to watch the trend.

Building the market context based on the trend and the divergence can give a lot of meaning about the price action that is evolving. Because divergences are leading indicators, they can be partly right. Thus, the concept of trends will help you to avoid trading divergences in isolation.

The above five tips for trading divergences are not the only way. You can of course develop your own trading rules or tips when trading with divergence. Experience and practice are two of the most important aspects you need to have when using divergence based trading methods.

Read 901 times Last modified on Sunday, 14 July 2019 08:31