Introduction
What’s the first thing that comes up in your mind when you hear the term Price Action? Most of the people would say, trading without the indicators. Well, that is correct. Price Action means analyzing the charts by observing the movement of prices. And, Some Price Action traders use the divergence indicator as well. However, the indicator is not used as the primary tool for analysis but is used as a confirmation tool if the analysis is correct. They do not take trades based on what the indicator is indicating but take them purely on price Action analysis.
Prerequisites
When do we use divergence?
We use the divergence indicator usually when the market is in a trending mode.
What is a trend?
A Trend is basically the state of the market. There are two trends in the market, an uptrend and a downtrend. An uptrend is determined by a higher high and a higher low, while a downtrend is recognized by a lower low and a lower high.
Below is a self-explanatory example of an uptrend and a downtrend:
Therefore, when we have any one of the two trends active in the market, we can apply the divergence indicator.
What is divergence?
Divergence is that topic which lies in between easy and difficult. Everyone would have studied the divergence indicator as per the textbooks. But, here in this article, you will learn about it in a different way.
Let us understand the meaning of divergence with an example.
The below picture is a representation of a candlestick chart with the MACD (divergence) indicator below it. We see that there is a lower low on the candlestick chart, but there is no lower low on the MACD indicator. This is called divergence in the market.
We can clearly see that the market is in an uptrend making higher highs. There is a higher high on the chart, but there is no higher high on the MACD indicator. Hence, divergence in the market.
Below is an example which represents that there is no divergence in the market.
Why does a divergence happen in the market?
Now that we know what divergence is let us understand “why” a divergence happens in the market. Before that consider the below picture which represents the default setting in the MACD indicator. The numbers 12 and 26 imply that the indicator uses the average last 12 and 26 candles to plot the MACD lines. Let’s not dig much into this as it is not very significant. All we have to know is that the MACD indicator uses the average of the last few candles to plot the lines.
Consider the below figure. The left figure is the chart on a higher timeframe, and the right figure is the same chart on a lower timeframe. We can see that the lower timeframe gives finer details about the movement of the price. It is observed that there are several subdivisions for every higher high. However, on the last up move, there are no subdivisions.
The indicator considers the average of the last 12 candles for plotting the graph. In the circle, we can say that 11 out of 12 candles were moving down, and only one candle went up. If we take the average of these candles, the average will signify that the market is still in a downward momentum as most of the candles were going down. Now, the chart says that the market is bullish, while the indicator indicates that the market is bearish. Hence, we see a divergence in the market as both (chart and indicator) are pointing towards two different things.
So, what next?
Now that we clearly understood the meaning of divergence and its reason for the occurrence let us understand what should be done when a divergence is spotted in the market. When the market is in a trending state, if a divergence is observed, the first and foremost rule is to stop trend trading as the market is indicating that there is something wrong with the trend. So, basically, divergence is a tool that can be used to determine if the trend is healthy or not. In other words, it determines if it is safe to trade a trend pullback.
Doing it the Price Action way
In the above explanation, we saw that a divergence in the market indicates that there is a problem with the trend, and there is less possibility that the trend will continue further in that direction. So, price action traders use this information to their advantage.
A complete trade example
In the given example, the market is in an uptrend. It is arguable that the market is in a downtrend. Though, it is not incorrect saying that it is in a downtrend. However, a price action trader is always concerned about the overall trend of the market and not the recent trend. This is what makes a price action trader better than the average traders. Going forward, the pullback starts to come in by making lower lows and lower highs. But, in the last lower low, we observe a divergence in the market, which is an indication that the downtrend is weakening. Therefore, as the overall trend is in an uptrend and the current downtrend is losing strength, this confirms that the big buyer has stepped in the market. Hence, we can anticipate a buy anywhere in the circled region.
The result of the trade is as given below:
Therefore, beginners can use this indicator as a risk control tool, while other traders can use it in conjunction with technical analysis as a tool of confirmation.
