Divergences are used by traders in an attempt to determine if a trend is getting weaker, which may lead to a trend reversal or continuation.
Before you head out there and start looking for potential divergences, here are nine cool rules for trading divergences.
Learn ’em, memorize ’em (or keep coming back here), apply ’em to help you make better trading decisions.
Ignore them and probably go broke.
Okay, maybe not instantly broke. But your win rate will suffer, and your account will thank you for reading this lesson. Let’s go.
1. Make Sure Your Glasses Are Clean
In order for a divergence to exist, the price must have formed one of the following:
- Higher high than the previous high
- Lower low than the previous low
- Double Top
- Double Bottom
Don’t even bother looking at an indicator unless ONE of these four price scenarios has occurred.
If not, you ain’t trading a divergence, buddy. You’re just imagining things. Immediately go see your optometrist and get some new glasses.
This is an important starting point because it forces you to begin your analysis with price, not the indicator. A lot of beginners make the mistake of staring at the oscillator first and then trying to find a matching setup on the price chart.
That’s backwards. Price leads the analysis. The indicator confirms (or doesn’t confirm) what the price is doing.
If you look at a chart and see messy consolidation with no obvious extreme tops or bottoms, there’s nothing to work with. Move on.
2. Draw Lines on Successive Tops and Bottoms
Okay, now that you’ve got some action (recent price action, that is), look at it. Remember, you’ll only see one of four things: a higher high, a flat high, a lower low, or a flat low.
Now draw a line backward from that high or low to the previous high or low. It HAS to be on successive major tops/bottoms.
If you see any little bumps or dips between the two major highs/lows, do what you do when your significant other shouts at you: ignore it.
Why successive? Because if you skip over a swing high or low in between, you’re no longer comparing adjacent momentum readings.
You might be connecting two points that are so far apart that the relationship between them is meaningless. Keep it clean, keep it sequential.
3. 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.
Don’t make the mistake of drawing a line from a swing high to a swing low. That’s like comparing apples to carburetors. It makes no sense.
See how clean that looks? Tops connected to tops. That’s the only way to do it.
Now here’s what NOT to do:
4. Keep Your Eyes on the Price
So you’ve connected either two tops or two bottoms with a trend line. Now look at your preferred technical indicator and compare it to price action.
Whichever indicator you use, remember you are comparing its TOPS or BOTTOMS.
Some indicators, such as MACD or Stochastic, have multiple lines all up on each other like teenagers with raging hormones.
Don’t worry about what these kids are doing. Focus on the peaks and valleys of the main signal line.
For the Stochastic, compare the %K line’s highs or lows. For the MACD, use the MACD line itself (not the signal line). For RSI, it’s simpler since there’s only one line to track.
5. Be Consistent With Your Swing Highs and Lows
If you draw a line connecting two highs on price, you MUST draw a line connecting the two highs on the indicator as well. Ditto for lows.
If you draw a line connecting two lows on price, you MUST draw a line connecting two lows on the indicator. They have to match!
This seems obvious, but you’d be surprised how many traders connect highs on price and then accidentally compare them to lows on the indicator.
Once you start looking at divergences on busy charts with a lot of price action, it’s easy to lose track. Stay disciplined.
6. Keep Price and Indicator Swings in Vertical Alignment
The highs or lows you identify on the indicator MUST be the ones that line up vertically with the price highs or lows.
It’s just like picking out what to wear to the club. You gotta be fly and matchin’, yo!
Notice how each price high sits directly above its corresponding indicator high? That’s what proper vertical alignment looks like. If you dropped a straight line down from the price peak, it would land right on the indicator peak.
Always double-check the vertical alignment. If the timing doesn’t match, the divergence isn’t valid.
7. Watch the Slopes
Divergence only exists if the SLOPE of the line connecting the indicator tops/bottoms DIFFERS from the SLOPE of the line connecting the price tops/bottoms.
The slope must be one of three things: ascending (rising), descending (falling), or flat.
In the pink example, price made a lower low while the indicator made a higher low. The slope of the price line is descending, while the indicator line is ascending.
Those are different slopes. That’s divergence.
In the blue example, both lines are sloped in the same general direction (up). Both price and the indicator are rising together. No divergence there, just confirmation that the trend’s momentum is intact.
Here’s a simple test: If someone asked you, “Are these two lines going in the same direction?” and the answer is yes, there’s no divergence.
If the answer is “No, they’re going in different directions,” you’ve likely found one.
8. If the Ship Has Sailed, Catch the Next One
If you spot a divergence but the price has already reversed and moved in one direction for some time, the divergence should be considered played out.
You missed the boat this time. All you can do now is wait for another swing high/low to form and start your divergence search over.
This is hard for a lot of traders to accept.
You see a beautiful divergence setup, and your brain says, “I can still get in!”
But if the move has already happened, your risk-to-reward ratio is terrible. You’d be buying after the bulk of the rally has already occurred, with your stop loss far below.
That’s not a trade. That’s FOMO.
The market will always give you another opportunity. Be patient and wait for the next fresh setup.
9. Take a Step Back
Divergence signals tend to be more accurate on longer timeframes. You get fewer false signals.
This means fewer trades, but if you structure your trade well, then your profit potential can be significant.
Divergences on shorter timeframes will occur more frequently but are less reliable.
Stick with looking for divergences on 1-hour charts or longer. Some traders use 15-minute charts or even faster. In those timeframes, there’s just too much noise for our taste, so we stay away.
Why do longer timeframes work better? It goes back to what we covered in the earlier lessons about momentum.
- On a 5-minute chart, a handful of large orders can cause a temporary momentum spike that looks like a divergence but is really just noise.
- On a daily chart, the oscillator readings reflect the accumulated momentum of thousands of traders over an entire session. That’s a much more meaningful signal.
If you’re new to divergence trading, start with 4-hour and daily charts. Once you’re consistently spotting valid setups on those timeframes, you can experiment with moving down to 1-hour if you want more frequent opportunities.
Wrapping Up
So there you have it!
Nine rules you MUST (should?) follow if you want to seriously consider trading using divergences.
Trust us, you don’t wanna be ignoring these rules. Your account will thank you for memorizing them.
Follow these rules, and you will increase the chances of a divergence setup leading to a well-structured trade. No guarantees in trading, but stacking the odds in your favor is what this game is all about.
Now go scan the charts and see if you can spot some divergences that happened in the past. Practicing on historical charts is a great way to train your eye before putting real money on the line!
What’s Next?
In the next lesson, we’ll give you a handy divergence cheat sheet that puts everything you’ve learned into a quick-reference format.
Perfect for those moments when you need answers on the fly!