Divergence is one of the strongest trading signals. This is the moment when the market is ready to go in the opposite direction. In indicator analysis, divergence occurs when the direction of price movement does not coincide with the direction of movement of the MACD indicator (included in the standard set of the MetaTrader terminal).

In our opinion, MACD with standard settings: 12 – 26 – 9 is best suited for divergence detection

In Forex, there is a difference between divergence (translated as divergence) and convergence (translated as convergence), although Elder described both of these signals with one term – Divergence. Divergence occurs when the price shows growth, while the indicator shows decline. Convergence is the opposite: the price is falling and the indicator is growing.

How to identify divergence with MACD

This is how the MACD indicator looks on a price chart:

We are interested in the gray bars – they are called the histogram. And also the zero level on the indicator – the histogram rises above it and falls below it.

The indicator also has a red signal line – traders use it in trading systems to open a position: they watch how it crosses the histogram and zero level. But it is not important for determining divergence, so we will not talk about it for now. We consider only the histogram and the zero level. This is quite enough to find the divergence signal.

The chart shows how the price and indicator readings diverge – we have shown it with red lines for clarity:

The price has set new highs on the uptrend after the correction – at the same time the tops of the indicator histogram are decreasing on the contrary. This is the divergence or divergence. High-quality divergence is quite a rare signal in the market and at the same time, as Elder claimed, it is very reliable and very rarely gives losing trades.

Qualitative and non-qualitative divergence

What can we consider a qualitative divergence? It is important that during a price correction (i.e. when the price is moving against the trend) the indicator histogram crosses zero before establishing a new peak on an uptrend or a minimum on a downtrend. After crossing zero, the histogram grows behind the price and does not set a new peak. Looking at the figure.

The trend from point 1 corrects to point 2, with the indicator histogram falling below zero at the moment of correction. Further, the price from point 2 grows again to point 3, and point 3 is higher than point 1. That is, the trend has set a new maximum for the price. But, the top of the indicator histogram opposite point 3 is much lower than the top under point 1. The market works out this signal-divergence by falling to point 4.

This is a high-quality divergence signal: the price peaks diverge from the indicator peaks, and at the moment of price correction the histogram crosses the zero level of the indicator.

Now let’s see what a low-quality divergence signal looks like according to Elder, which he did not recommend to use in trading.

As we can see, there is a divergence: the price is setting new peaks, while the indicator histogram is falling. But there is no good price correction, at which the indicator histogram falls below zero.

Further down the chart, the price did fall, but we would have to wait for the result for quite a long time. At the same time, the stop-loss could work. The essence of a good divergence is that it works out in profit quite quickly.

Here is a quality divergence, which showed the reversal of the downtrend:

The price shows a low, then a correction, during which the histogram crosses the zero level. Further the price shows a new minimum, but the histogram does not. As we can see, the price reversed after the signal.

What is convergence?

The classical interpretation does not describe any convergence. It is not known who invented it, but this concept has gained a foothold in Forex. Let us understand what is meant by it.

Let’s compare the two figures below:

In the first figure the trend lines diverge, in the second figure they converge. The convergence shown in the second figure is called convergence. After all, if divergence is translated as “divergence”, it is logical to call this term only those cases when the price and the histogram diverge from each other. And the cases when they converge to each other should be called convergence (translated as “convergence”).

It would seem really logical. In fact, it is not. This signal is called divergence not because the trend lines diverge, but because there is a divergence between the indicator and the price. It does not matter in which direction – towards each other or away from each other. The divergence between the price and indicator readings we observe in both figures, so in both cases we have a classic divergence.

Some people believe that divergence is a signal for a bullish trend reversal (from an uptrend to a downtrend), and convergence is a signal for a bearish trend reversal (from a downtrend to an uptrend). But classically both of these signals are called divergence.

You can often find also a description of divergence and bearish divergence, which has the same essence as convergence. Everyone can call divergence in his own way – the essence will not change.

Using divergence in trading

Divergence does not indicate where to place take profit. Targets on the deal will have to be determined by other methods, for example, using levels or candlestick analysis – depending on what the trader uses in his trading system.

The advantage of the signal is that the price quickly brings the deal to profit, and the percentage of false signals is very small – try to check the history of all divergences, and you will see that they end with a profit almost always.

But at what moment to open a trade?

Bar trading

Elder suggested opening a position against the trend – as soon as the indicator histogram starts moving towards the zero mark. That is, as soon as you see the first bar of the histogram, which is lower than the previous one (if the divergence is on an uptrend, on a downtrend – higher than the previous one) – immediately open a deal.

Stop-loss is set behind the existing extremum (price minimum or maximum). Although it is recommended to set a stop-loss with a reserve for some pro-trading – after all, the market can always throw a farewell hairpin and knock out the stop-loss, giving a loss instead of a profit.

Let’s consider an example. In the figure below, the histogram shows divergence on the downtrend. The new minimum of the histogram ends higher than the previous one. On the bar (division on the indicator histogram), which is closer to the zero line than the previous one, a buy trade is opened.

Let’s consider the same on a rising trend. We see a divergence, wait for the first falling bar of the histogram and open a sale. We put a stop loss above the maximum, leaving a margin for a small hairpin.

Breakout trading

We can also suggest to open trades not by histogram bars, which is quite aggressive in our opinion, but to wait for the breakdown of the level and open a trade on the breakdown.

In the figure below we have a support line (red oblique). The indicator shows divergence. The trader enters a sell trade on the breakdown and sets the SELL STOP order above the new price peak, which corresponds to the decrease in the histogram.

Trading using fractals

Another variant of entering a deal using divergence. The trader does not open a trade immediately after the first falling bar of the histogram appears. Instead, he looks at the nearest fractal (a standard MetaTrader tool) and places a SELL STOP breakout order below it.

This method more accurately determines the place of stop loss setting. After setting a breakout order behind a level or a fractal, you can place a stop loss strictly behind the formed extremum, leaving no room for retracement. The price is unlikely to update this extremum – only in case of a false signal. At the same time, an order behind the nearest fractal will allow you to use a smaller stop loss.

Where to take profits

As it was written above, it is impossible to determine the levels for profit taking based on this signal – divergence shows only where the market is likely to reverse. But how deep this reversal will be should be determined by other methods. The simplest way is to set take profit twice as big as stop loss.

We can also use divergence as the moment of correction completion. This method of taking profit is more complicated. Below is the chart on the daily timeframe (the same chart we have already considered above on the hourly timeframe). The red segments show the rising trend – the price moves up, then pulls back and sets a new maximum.

So, we are waiting for another correction to buy, hoping for a new wave of growth. In the place marked by the red rectangle, the indicator showed divergence (we have previously seen it on the hourly timeframe). Thus, the trader can clearly see where to fix the profit: the level, where the correction started from, will be the place to set take profit. As we can see, the price even updated it a bit.

There are many trading systems using divergence, you can develop any of them yourself. It is important to remember: divergence itself is a method of opening a position with the ability to determine the correction or price reversal. For a full-fledged system, a trader needs to develop the rules of profit taking and stop-losses, methods of capital management, i.e. what volumes will be used to open a deal.