If you’re new to trading, chances are this is the first time you’ve heard about divergence day trading.
In today’s social media-driven world, big words like “divergence” don’t go viral. But knowing this strategy could provide a lot of value for your trading career.
Divergence day trading has been around for a long time. Even longer than a dinosaur like me. And that means it’s stuck around for a reason.
If you don’t know, divergence means to separate from something. In trading, watching the right technical indicators diverge can help you a lot.
Divergence day trading is a great way to get a sense of where a stock will move next. And when it comes to momentum, we all want some kind of peek into the future, right?
Today, I’ll cover all the ins and outs of divergence trading. Plus, I’ll look at contenders for the best divergence indicator to use for your strategy.
Table of Contents
- 1 What Is Divergence Day Trading?
- 2 Why Is Divergence Day Trading Important?
- 3 How Accurate Is Divergence Trading?
- 4 Which Indicator Is Best for Divergence?
- 5 Types of Divergences
- 6 How Do You Trade with Divergence? 5 Rules to Follow
- 7 How Do You Confirm Divergence Day Trading?
- 8 How Do You Calculate Divergence Day Trading?
- 9 Bottom Line
- 10 One Platform. One System. Every Tool
What Is Divergence Day Trading?
Divergence day trading is a strategy for predicting trend reversals. By looking at the right set of data, you can make an educated guess about future price momentum.
This applies whether the trend is currently bullish or bearish. There are a few popular indicators to track. More on those in a bit.
Divergence trading can be a great way to get ahead of your competition. It’s a bit of an advanced strategy.
Most traders start with reading candlestick patterns. Then they pick up support and resistance zones and key levels. These are great tools and you can go far relying on them alone.
But if you want to learn all about another step that could help you in your game, read on. Divergence day trading might be the secret weapon you’re looking for.
Why Is Divergence Day Trading Important?
Divergence day trading is an important tool. It gives you valuable insight into the future direction of your stocks.
This can help you manage risk if you’re in a trade. Or it might help you get ahead of the crowd when you spot a solid emerging momentum trade.
If you’re already in a trade, seeing a divergence ahead of time can inform your next steps. For example, you could choose to keep holding or buy to cover. You could tighten your trailing stop or take partial profits.
If you check your favorite indicators and see the potential for a divergence day trade, go for it. Keep in mind that it won’t always go according to plan.
You have to get in right at the start of a trend change to make it work. If the momentum has already taken off, you missed the train! Don’t jump on board a moving train! It’s dangerous. Same reason you shouldn’t trade a breakout if it’s up too many green candlesticks already.
At the same time, remember that you’ll almost never pick the top or bottom of a trade. Be happy when you get a chunk of a move! Don’t let a desire for perfection stop you from locking in healthy profits.
A great way to catch momentum moves before everyone else is to stay on top of the latest news…
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What Is the Difference Between Divergence and Convergence Trading?
Divergence and convergence trading both refer to the directional movement of a stock. If you’re a retail trader like myself, it’s more important to know what divergence is, but let’s take a look at both.
Divergence day trading works when the price of a stock moves away from the current trend. That’s according to the indicator and oscillator of your choice.
With convergence trading, two separate trends move closer to each other. This strategy is more commonly used by trading firms that seek to profit from arbitrage.
Convergence trading is like a box trade but its aims are different. Convergence trading involves trading a futures contract and its underlying asset. Both at the same time.
Traders buy the futures contract and the asset it represents when the cash value of both are far apart. In an efficient market, the price difference cannot last. But when they don’t reach exact convergence, traders profit from buying and selling both.
The profits are usually small. But traded in large block orders, they can add up significantly.
How Accurate Is Divergence Trading?
The best answer I can give you?
Like all things day trading, it’s not an exact science, and it’s subject to some variability.
Shorter time frames are more likely to have noise or false signals in them. There’s a lot of volatility in a one-minute or five-minute chart.
Longer time frames tend to give you better results. There’s less noise and a clearer sense of direction. This means a one-hour chart or longer.
The later in the day, the more information you have. And the more information you have, the better your confidence in your trade. That’s why I love afternoon trading.
And if you want to improve your time frame analysis, there’s a certain book I recommend. It changed my trading game for the better. “Technical Analysis Using Multiple Timeframes” by Brian Shannon opened my eyes.
When you understand the mechanics of time frame analysis, you’ll see momentum in a whole new way. And you’ll understand what makes a certain time frame work the best for a given trade.
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Which Indicator Is Best for Divergence?
There are a few common indicators for divergence day trading many experienced traders use. Their popularity helps make them more accurate. It’s like a self-fulfilling prophecy!
Two key indicators are the relative strength index (RSI) and the moving average convergence divergence (MACD). They’re especially helpful to use when you’re setting up a good swing trade. But they’re great to stay aware of while you day trade as well.
The RSI compares the average gain or loss over a certain period. It’s common to set your RSI to 14. This means the RSI will compare the last 14 bullish and bearish candlesticks.
When RSI is low, there are more bearish than bullish candles in that period. And when RSI is high, there are more bullish than bearish candles. Candle size is also taken into account.
Typically, when RSI hits over 70, a stock is overbought and likely to turn bearish. When RSI drops below 30, the stock is oversold and likely to turn bullish.
The MACD measures the relationship between moving averages in a stock’s price chart. Traders often look for the MACD to fall below the zero line on a chart. This can be a good time to enter a trade.
When the MACD line crosses over its signal line, you can expect bullish momentum. When the MACD line crosses below its signal line, expect bearish momentum.
It’s important to watch when either of these indicators diverge from the price action on a chart. That’s what makes a great setup for a divergence day or swing trade.
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Types of Divergences
There are a few types of divergences to look out for. Each indicates a potential for a price reversal. Pay attention to the slight differences to make the most of them.
Remember that the chosen indicator points to what might happen next. And it does so before the price chart.
Hidden Bullish Divergence
Hidden bullish divergence happens when the following two factors align … First, the indicator makes lower lows. Second, the price chart makes higher highs.
This can mean the price action will soon reverse to the downside.
Hidden Bearish Divergence
Hidden bearish divergence happens when the indicator makes higher highs and the price chart makes lower highs.
This can mean the price action will soon reverse to the upside.
Regular Bullish Divergence
Regular bullish divergence happens when the indicator makes higher lows and the price chart makes lower lows.
This can mean the price action will soon trend upward.
Regular Bearish Divergence
With regular bearish divergence, the indicator makes lower highs and the price chart makes higher highs.
This can indicate the price action will soon trend downward.
How Do You Trade with Divergence? 5 Rules to Follow
1. Always Confirm Divergence
Do this before entering a trade. (Find the four telltale signs in the next section.)
2. Connect the Highs
When you draw a trendline to connect higher highs, always connect the tops of the candlesticks.
3. Connect the Lows
When you draw a trendline to connect lower lows, always connect the bottoms of the candlesticks.
4. Never Chase Divergence
If you missed the pivot point and a new trend is already in progress, don’t trade it. Wait for the next one.
5. Stick to Longer Time Frames
Some traders use 15-minute charts, and that’s OK. But it might still have some noise in it. One-hour charts are the starting point for the most accurate readings.
How Do You Confirm Divergence Day Trading?
Divergence day trading follows four simple rules. If you don’t see one of these four things on your price chart, no need to check the indicator. It won’t be divergence trading.
- A higher high than the previous high.
- A lower low than the previous low
- A double top chart pattern
- A double bottom chart pattern
One of these four things MUST be in play. So always check for these first.
I know this is a lot to keep track of when you’re new to trading. That’s why it helps to have a team at your side…
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How Do You Calculate Divergence Day Trading?
The most important thing is to make sure your price chart and indicator vertically align.
They must measure action in the same time span for an accurate comparison.
When you identify a trend change, put a stop loss close to the point where the trend reversed. Give it a small buffer so it can retest the pivot point if it needs to. But keep it small. If the reversal doesn’t hold, you’ll want out. Cut losses quickly.
If the trend goes in the direction you expect, your price target can be a multiple of your risk. Or you can look for key levels to use as support and resistance zones.
Also, be aware of what’s happening in a longer time frame. For example, if you want to trade based on a 15-minute chart, check the one-hour chart first. And if you want to trade based on the one-hour chart, check the four-hour chart first.
Going up in time frames helps you get a sense of the bigger picture. Then, zoom in to your desired time frame and place your trade. A sniper’s always aware of their surroundings.
Whether you’re a newbie or veteran trader, divergence day trading can help you get an edge. And it’s a lot of fun to look out for.
Let’s face it, a lot of newbie traders come into the markets without much knowledge. They watch stocks go up, get excited, and buy shares at a high price. Then they see the price decline, get scared, and sell everything at a loss.
Sometimes they get lucky though. They buy the dip and it happens to work out in their favor. That hooks them and keeps them coming back for more. We’ve all been there. It’s always the lucky win that hooks us.
But for the most part, newbies trade blindfolded. They don’t know WHY stocks move up or down. And they don’t know where they’ll go next … until they find an edge.
Then the patterns make sense. And best of all, they repeat! This gives traders the opportunity to build intuition and choose the right indicators.
Once you’ve found your favorite set of indicators, you can use them over and over. When you have a hunch, confirm it. Then place your trade. Review what happened. Rinse and repeat.
Have you ever used divergence day trading? What’s your favorite indicator? Let me know in the comments below!