Trading bullish and bearish divergences is a popular strategy to take advantage of the price movements in the forex market. While there are numerous strategies to use technical analysis as a useful tool to make profits, trading bullish and bearish divergences is said to be one of the most powerful approaches of them all. How it works and what you need to know about it isis explained in detailly in the following text.
First of all, we have to specify where we want to apply this strategy. In the most common way, bullish and bearish divergences are observed in the Relative Strength Index (RSI), the Moving Average Convergence Divergence (MACD) and the Money Flow Index (MFI).
The Relative Strength Index (RSI) is shown as the purple wave above the price chart in the example below. As you can see, there are two dotted lines, one at the top and one at the bottom. If the RSI reaches above the line, the RSI signals us that the price is in overbought regions, indicating that there will be a sell-off soon enough.
The opposite case holds true if the RSI falls below the line at the bottom. If the RSI reaches oversold regions, it indicates that the recent drop will soon come to an end and there will be a wave towards the upside in the not-too-distant future.
As seen above, the RSI touching or overreaching the dotted lines often resulted in tremendous price movements in the opposite direction. Thus, the RSI is a very powerful tool to find entry levels for long and short positions.
In the chart above, the RSI shows a bearish divergence. If the price climbs higher while the RSI performs lower highs, it indicates that there will be a (massive) sell-off in the near future. The bigger the timeframe, the bigger the price movement. In this example, EUR/USD lost 15 percent after the divergence formed over two years in the monthly chart.
In the bull case seen below, the RSI must form higher lows while the price is performing lower lows. In this case, the price climbed nearly 5 percent after the bullish divergence formed in the daily chart.
The same strategy can be applied to the Moving Average Convergence Divergence (MACD) indicator.
In the example below, the MACD shows a bearish divergence in the monthly chart. If we want to spot a bullish or bearish divergence in the MACD, we look at the green histogram and not at the blue and red lines. Thus, it can be observed that the histogram forms a lower high while the price was continuously climbing higher to form new highs. As indicated by the bearish divergence in the MACD, a massive price drop of more than 20 percent occurred after that.
The same principle is applied when spotting a bullish divergence in the MACD, but of course, in the opposite way. The MACD forms a higher low while the price chart is showing lower lows. This divergence indicates that a trend switch in the opposite direction is about to take place very soon. The price chart acted accordingly, surging by nearly 100 percent after the bullish divergence formed.
The money flow index works similar to the RSI, showing overbought and oversold regions to indicate trend switches. Unlike the Relative Strength Index (RSI), the Money Flow Index combines both price and volume data, as opposed to just price. Because of that, some analysts refer to the MFI as the volume-weighted RSI.
Looking at the weekly chart of EUR/JPY, the MFI shows a series of lower highs while the price chart is forming higher highs. The principle is exactly the same as in the RSI and shortly after the bearish divergence formed, a heavy price decline of nearly 27 percent took place.
What we can see below is the EUR/JPY daily chart. The money flow index shows a bullish divergence forming higher lows while the price continues to decline to form new lows. Thus, if we would trade according to the divergences strategy, we would have considered placing a long position after the bullish divergence has formed, which would have resulted in a 4 percent profit.
It is advised to take the bodies and not the wicks of the price movements to spot bullish and bearish divergences. This way we ensure that the divergence is correct and not a false signal.