Lesson 2: 9 Rules You Must Know When Trading Divergences

Market divergences are an essential tool for identifying a weakening market trend. With divergence, you can tell a market that may have trend reversal or continuation.  

Sounds cool, right? Well, before you enter the market with this new knowledge, here are the 9 cardinal rules when trading divergences. Follow these rules and you increase your chances of profiting from the market with divergence. 

Lesson Highlights

• Trading market divergence presents profitable opportunities and risk-mitigating techniques to traders. With the divergence indicators, a trader refers to the potential direction the market will tread.
• While profitable, trading market divergence can confuse beginner traders, which may result in investment losses and even capital ruins. To battle this, traders must follow nine divergence trading rules.

Rule 1. Make sure it's a divergence 

Remember, divergences don’t exist in all markets. So, don’t enter the forex market thinking that the asset market has an existing divergence. 

But how do you know that the market has an existing divergence? Here are the four formations that points to an existing divergence; 

1. The market has a higher high than the previous high. 
2. The asset is experiencing a lower low than the previous low. 
3. The market has a double top pattern. 
4. The market has a double bottom pattern. 

Again, only these trends indicate a potential divergence. If nothing like this is happening to the market, then aligning your strategy to your supposed divergence will just be a waste.  

With wrong divergence, you subject your positions to false signals, consequently harming your decision-making and potential losses. 

Rule 2. Draw lines on successive tops and bottoms 

After confirming the divergence, the next logical course of action is to check the successive tops and bottoms. Here are one of four things;  

1. A higher high 
2. A flat high 
3. A lower low 
4. A flat low 

Now, draw a line backward from that high or low to the previous high or low. It must be on successive major tops/bottom.  

If you see any little bumps or dips between the two major highs/lows, the best thing to do is to ignore it. 

Rule 3. Know what to connect: Tops and Bottoms only 

Once you see two swing highs are established, you connect the tops. If two lows are made, you connect the bottoms.  

So, what does this tell you? There are only swing highs when there is a higher high; likewise, swing low is only possible in the market with lower lows.  

Remember, you don’t connect top to bottom; and vice-versa.  

Rule 4. Focus on the Tops and Bottoms 

After you connect the tops (higher highs to the previous high) or the bottoms (lower lows to the previous low), you now use your preferred technical indicator and compare it to price action.  

But remember that whichever indicator you use, they just compare one thing; the market’s tops or bottoms. 

Some indicators such as MACD (Moving Average Convergence Divergence) or Stochastic oscillator have multiple lines that are up on each other.  

Rule 5. Be consistent with swing highs and swing lows 

Being consistent in your drawing of swing highs and lows shall be applied to both chart price and the indicator you’re using.  

If you draw a line connecting two highs on the price chart, you must draw a similar line on the indicator as well. The same for the lows also.  

Remember your drawing for swing highs and swing lows must match!  

Rule 6. Keep it in vertical alignment 

The highs and lows you identify on the indicator must be the ones that line up vertically with the price highs or lows.  

Always maintain a vertical alignment with the price’s swing highs and lows with the indicator’s swing highs and lows.  

Rule 7. Have an eye for slopes  

Divergence only exists if the slope of the line connecting the indicator’s tops/bottoms differs from the slope of the line connection price tops/bottoms.  

The slops can either be: 

1. Ascending (or rising) 
2. Descending (or falling) 
3. Flat 

Remember, if the price movement in the price chart and the indicator are moving inversely, you can expect a divergence to happen. If the price points for both are moving in the same direction, it’s safe to assume that no divergence is happening.  

Rule 8. Never trade a played-out divergence 

Assume you spot a divergence, but you realized that the price has already reversed or moved in a certain direction for some time, you need to consider it as an already played-out divergence.  

And one golden rule is to never, ever, trade a played-out diversion. Remember, if the train has already departed, don’t dare catch it because there will be a next one.  

Rule 9: Avoid market noise and focus on the longer time frames 

Pro tip; divergence signals tend to be more accurate on the longer time frames.  

But does that mean you get to trade less than usual? Sadly, yes. But with a well-structured trade, your profit potential can be huge.  

If you trade as frequently as you do, but your profit-loss offset each other, you basically gained nothing.  

Why not trade divergences on shorter time frames? Simply because they’re less reliable. If you use 15-minute charts, you subject your analysis to market noise. With tons of deafening market noise, it’ll be harder to analyze potential divergence.