While employing divergences is an excellent weapon to have in your trading arsenal, there are situations when you may enter too soon since you did not wait for more confirmation.
If you continue to enter too early, you will get stopped out, and your losses will mount. And you know what happens when even minor losses add up? You become bankrupt.
You’ll end up with a divergence between your thoughts and your wallet regarding your wealth. Here are a few techniques of the (divergence) trade you can employ to increase your confidence that the divergence will work in your favor.
Wait for and Indicator Crossover
This is more of a rule than a trick. Simply wait for the momentum indicator to cross.
This could suggest a change in momentum from buying to selling or vice versa.
The main reason for this is that you are waiting for a top or bottom, which cannot be formed unless a crossover occurs!
The pair made lower highs in the chart above, but the Stochastic made higher highs. That’s a bearish divergence, and it’s tempting to short straight immediately.
But, as the saying goes, patience is a virtue. It’s best to wait for Stochastic to cross down as proof that the pair is truly heading down.
The Stochastic did hit the crossing a couple of candles later. That bearish divergence would have been fantastic to play!
What is the major point of this? Simply be patient! Don’t try to go ahead of the game since you never know when the momentum will shift!
If you aren’t patient, you can get burned as one side continues to dominate!
Wait for the indicator to move out the overbought/oversold zone.
Another strategy is to wait for momentum highs and lows to reach overbought and oversold levels, then wait for the indicator to move out of these zones.
The reasoning is similar to that of waiting for a crossing in that you have no idea when momentum will begin to shift.
Assume you’re looking at a chart and see that the Stochastic has created a new bottom but the price has not.
Because the signal is indicating oversold conditions and divergence has occurred, you may believe it is time to purchase.
However, selling pressure may remain intense, causing the price to fall further and set a new low.
You would have been disappointed if the trend had not continued.
In fact, the pair is forming lower highs, implying that a fresh decline has begun. If you were obstinate, you might have lost out on this down move as well.
If you had waited patiently for more proof that the divergence had occurred, you could have avoided losing and recognized the emergence of a new trend.
Draw trend lines on the momentum indicator.
This may appear absurd because trend lines are generally drawn only on price activity.
But here’s a neat little tip we’d like to share with you. After all, having another weapon in the holster can’t hurt, right? You never know when you’ll need it!
This technique is particularly effective when looking for trend reversals or breaks. If you notice that price is following a trend line, consider sketching a matching trend line on your indicator.
You may observe that the indicator respects the trend line as well.
If both price action and the momentum indicator break their respective trend lines, it may indicate a transfer in power from buyers to sellers (or vice versa) and a change in trend.
Next Lesson: 9 Rules for Trading Divergences