Lesson 1: What Is Divergence in Forex and How Do You Trade It?

Ever noticed these two very common market trends? 

The price chart is hitting higher highs, but the indicator shows otherwise.

Or,  

The price is at the lower lows; however, the indicator is approaching higher highs. 

If yes, then you've just witnessed a divergence trend in the forex market. In this lesson, you'll dive deeper into divergent market trends and the best practices to capitalize on them.

Lesson Highlights

• Market divergence is a trading phenomenon where the market indicators move differently from the actual market movement. This market trend suggests that the primary trend is potentially unsustainable because it’s weak.
• The divergence extremes are the Higher Highs (HH), Higher Lows (HL), Lower Highs (LH), and Lower Lows (LL).
• There are two types of market divergence balance: Positive and Negative. A positive market divergence suggests a bullish trend, while a negative market divergence suggests a bearish trend.

Role of Divergence in Forex Market 

The most common strategy when trading forex is buying at the bottom and selling at the top. Why?  

Buying and selling assets this way ensures that you buy at the lowest possible price and sell at the most profitable price.  

While this strategy has proven beneficial, it still has challenges as it requires you to accurately and consistently identify the market extremes (the tops and bottoms). If you've been trading, you know that doing so involves significant risks.  

To battle this buy-low, sell-high challenge, you can trade market divergence. 

By trading the divergence, you can avoid strictly identifying the market extremes. In this strategy, you don't execute your trade at the exact extremes; you buy and sell near it.  

To do that, you simply look for the discrepancy between the asset's current price movement and the trend shown by your indicators.  

But what importance would this bring to you? Trading divergence, you get to see the potential trend reversal or continuation, which allows you to position your trade ahead of everyone.  

The Highs and Lows 

When you trade market divergence, there are price movement patterns you must constantly look for. These are the highs and the lows 

Higher highs 

The higher highs (HH) refer to a pattern where the high point (market peak) in the price of an asset is higher than the previous peak. 

It indicates upward momentum and suggests that buyers are in control. 

Higher lows 

Contrary to the HH, higher lows (HL) refer to a pattern where the asset price's low point (market trough) is higher than the previous trough. 

It also indicates upward momentum and suggests buyers are willing to enter at higher prices. Consequently, it can potentially form a series of ascending lows 

Lower lows 

Lower lows (LL) refer to a price pattern where the trough is the asset price is lower than the previous low point. 

It indicates downward momentum and suggests that sellers are in control. 

Lower highs 

The term lower high (LH) refers to a pattern where each peak in the asset price is lower than the previous high point. 

It also indicates downward momentum and suggests that sellers are willing to enter at lower prices, forming a series of descending highs 

Positive and Negative Divergences 

Using market divergence in your trading arsenal is an effective strategy and risk-management technique. Why?  

By looking at the market divergence, you'll know about the potential trend continuation or reversal. If it suggests a continuous market trend, you can make an informed decision for your entry point. 

If it suggests a market reversal and you have a positioned trade, you can act on it to profit or be safe from the reversal. 

But how do you use market divergence when you're trading? Well, the common use of divergence is to use its balance. 

1. Positive divergence: This signals a potential upward trend in price movement. When this happens, market sentiment will be bullish. 
2. Negative divergence: This signals a potential decline in the asset's movement. When this happens, the market will be bearish. 

With these divergence levels, you can easily find the most profitable entry point for your positions. Opening a long position when the divergent is positive is profitable because your position will profit from the upward market movement.  

Meanwhile, going short when the market divergence becomes negative is profitable because you'll profit from the downward market trend.  

The best part? Trading the divergence makes the risk of your position relatively smaller than your potential reward.