How to avoid trading a false divergence signal? This is the most important question when you trade divergences. You must read through this post as I am going to reveal a secret method to you that is so simple yet unknown to most other traders. Often times it will happen like this. You spot a divergence pattern. Suppose it is a bullish divergence pattern. You immediately pounce on it and enter a buy order with the stop loss some pips below the recent low made by the price. To your horror, you find the price going up then reversing and turning down, hitting the stop loss and making a new low. Take a look at the following screenshot!
As you can see MACD, Stochastic and the RSI, all the three indicators are showing bullish divergence below the down red arrow. The price did go up but then it reversed and made a new low. If you had immediately opened a buy trade on spotting the first divergence pattern, your stop loss would have been hit after 5 hours. Now take a look at this screenshot as well.
This time a bearish divergence pattern is appearing on H4 timeframe. MACD, Stochastic and the RSI, all three indicators are telling in unison there is bearish divergence trade it. And if you had traded it, you would have found the price going up not down. These type of divergence signals are know as False Divergence Signals.
As you can see we spotted a divergence pattern. Until and unless you don’t know how to filter out these false divergence signals, you won’t become a successful divergence trader. The solution is very simple. You will be amazed when I will explain it to you. Take a look at the following screenshot. But we are not going to immediately trade it. Since this is a bullish divergence pattern, we will let the Stochastic go from overbought to oversold and enter into a trade shown by the second red arrow below the stochastic. Price had made a low at 1.51738 and at the second red arrow the low made by price was 1.51982. So you can see since the price did not go below the previous low, it confirmed that the trend is up now plus we could get in around 1.5200 level with a stop loss ranging between 25-35 pips. So it is must for you to not immediately trade a divergence signal until and unless you have confirmed it by letting the Stochastic complete one cycle. No matter what timeframe you are trading, you should let the stochastic make one cycle before you trade that divergence signal. Take a look at the following screenshot.
Did the price go down? MACD, Stochastic and the RSI are showing bearish divergence on H4. Now the price went up and made a new high. Infact what we are encountering is the multiple divergences or what we call serial divergence which are frequent and common. So it is must for you to confirm the divergence signal before you make an entry. Now take a look at the following screenshot.
In this screenshot which is just the above screenshot again price went up and made a bearish divergence pattern again second time. So what we are getting is multiple or serial divergence. Now you will not trade it until the stochastic completes one cycle and it goes down to oversold then goes back up to the overbought level. We will enter near the second arrow as shown in the above screenshot. Price had made a high of 1.52609 above the first red arrow and it made a high of 1.52590 above the second red arrow confirming that the trend is indeed down now. This is an important rule that will help you avoid trading a false divergence signal like that above. When you spot a divergence pattern, you are not going to trade it immediately. You are going to let the Stochastic complete one cycle and see if the price breaks the previous low or the previous high. If it doesn’t, you have confirmed your signal. Now divergences can be used to trade any instrument whether it is stocks, currencies, commodities, ETFs etc. So once you master this powerful concept, you can use it on any instrument that you are trading. Read this article written by Candy Schaap on divergences.
Greetings, Hassam, I would like to ask you a question. In series Divergence articles The Stochastic indicator have different setups: someitmes it (9,3,3), sometimes (5,3,3), sometimes it (8,5,4). Have you any rule when to change that setups? Thanks for answer.
I have tested these 3 settings. 5,3,3 is too fast. 9,3,3 is slow plus the fast line and slow line are so close you can’t figure out when they are crossing. 8,5,4 separates the fast line from the slow line and you can easily draw the divergence signals. I hope this helps. Please let me know if you have further questions.