Trading Divergences - An Alternate View for New Traders

OANDA:GBPNZD   British Pound / New Zealand Dollar
Trading divergences is a very common technical analysis strategy, but it comes with one big problem: the most common divergences (not hidden) trade against the trend. This means that new traders can often get into trouble by constantly looking for, and trading, against a dominant trend.

Here's an idea to help you become more profitable over the long-term: identify divergences on your chosen momentum indicator , but only trade on trend continuation signals. I'm not saying you need to do this forever, as once you're experienced you can trade both pullbacks and continuations - but doing so requires multiple layers of confirmation, and a lot of knowledge/planning/experience.

By trading trend continuation signals after divergences, you're stacking the odds in your favour by going with the dominant trend. You're also training your eye to see divergences, and seeing how the markets react to divergences. For new traders this can be a valuable lesson in the power of momentum in financial markets.

So, what are trend continuation signals? It depends on your chosen momentum indicator , so I can only provide general ideas; you need to adapt things according to what you're using. My chart contains a custom momentum indicator , loosely based on the RSI . However, it's far smoother than the RSI , so I can reliably trade precise signals (e.g. for me, a cross of 0). On the RSI , you may choose something a bit further down the scale, for example, a cross below Oversold (20/30). If you're using a Stochastic indicator, you may trade a cross below Overbought (70/80). If you don't understand why I'm suggesting you trade signals at the opposite end of the scale for RSI and Stochastic , let me know.

Hopefully this all makes sense, and remember that it's just an idea if you're a new trader and struggling to make good trades.

Let me know if you have any queries.

Comment: An alternative of the alternative, but applying the same principal:


Hello, thanks for the educational. I ll like to understand this clearly, please. If I am using a Stochastic indicator, what is the reason I should trade a cross of 0 below Overbought (70/80)? I ll like to understand more why you suggested trading signals at the opposite end of the scale for RSI and Stochastic.
@Aikay1, Thanks for the comment.

In a nutshell, RSI wasn't designed as an OB/OS indicator, whereas the Stochastic was. RSI will stay low for long periods during a sustained down trend, and rarely reaches OB in a downtrend (if it does, that's a warning sign, which is why you don't trade a cross of OB, you trade a cross of OS). Stochastic is designed to travel between the levels of 0 (OS) and 100 (OB) - and to do so far more quickly than the RSI. Given that you're wanting to trade WITH the trend, you're looking to take signals in that direction - for the Stochastic you're looking for price to become OB in a downtrend, and for RSI you're looking for momentum to reach a critical point/mass.

Think of momentum like a train... it takes time to build up speed/power, but once it does, it doesn't stop quickly. Which is why trends rarely, if ever, reverse quickly. There's always some volatility and back and forth while the markets work themselves out. I've attached a screen below. You can see that neither signal is better than the other, really. It just depends how you're trading. For example, I think a good system would be taking RSI crosses below OS, but using those as re-entry points, and holding all those trades while price is below the 200SMA. Theoretically, this should help to avoid whipsaws.
Aikay1 DreamsDefined
@DreamsDefined, Grateful.
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