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 go broke.
1. Make sure your glasses are clean
In order for divergence to exist, price must have either 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
have 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.
2. Draw lines on successive tops and bottoms
Okay now
that you 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/bottom. 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.
3. Do Tha Right Thang - 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 trying to draw a line at the bottom when you see two higher
highs. It sounds dumb but really, peeps regularly get confused.
4. Eyes on the Price
So you've
connected either two tops or two bottoms with a trend line. Now look at your
preferred 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.
5. Be Fly like Pip Diddy
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 also. 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!
6. Keep in Line
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!
7. Ridin' the slopes
8. If the ship has sailed, catch the next one
If you
spot 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.
9. Take a step back
Divergence
signals tend to be more accurate on the longer time frames. You get less false
signals. This means fewer trades but if you structure your trade well, then
your profit potential can be huge. Divergences on shorter time frames will
occur more frequently but are less reliable.
We advise
only look for divergences on 1-hour charts or longer. Other traders use
15-minute charts or even faster. On those time frames, there's just too much
noise for our taste so we just stay away.
So there you have it kiddos - 9 rules you MUST follow if you want to seriously consider trading using divergences. Trust us, you don't wanna be ignoring these rules. Your account will take more hits than BabyPips.com's Facebook fan page.
Follow
these rules, and you will dramatically increase the chances of a divergence
setup leading to a profitable trade.
Here's an example of how a bearish divergence failed. Can you figure out which
of these 9 rules Cyclopip broke?
Now go
scan the charts and see if you can spot some divergences that happened in the
past as a great way to begin getting your divergence skills up to par!
