Divergence is a Very Powerful Indicator
A trend trader’s best defense is knowing how to define counter-trending price behavior for sure. And a very good indicator that counter-trending price action is occuring on the lower itme frames is seeing divergence between price and the momentum on the higher time frames. As much emphasis as we put on trend trading by encouraging students to trade in the direction of the higher time frames, we understand that this is only one part of the equation, and to understand what a trend trade is, we need to be able to recognize when a trade signal is counter to the higher time frame trend.
In the graph below we have a 60-minute chart of GBPUSD in the bottom panel and a 15 minute chart in the top panel. We see onthe 60-minute chart what turns out to be a trend move ending on exaustive momentum. At the time however we dont’ know that. We did however know it was a trend move because price direction was down on the 240 minute and daily charts.
This price action on the 60-minute chart tips us off that we do not want to press shorts on the lower time frames. Astute trades can even consider counter-trend buy signals on those lower time frames in anticipation of a rally to relieve the pressure of an oversold market which the inital divergence pointed out.
It’s very important to point out here that a true trend trader is not going to be concerned about this back and forth price action on the lower time frames. From the perspective of a trend trader who enters and exits trades on a Daily chart, counter-trending price action is simply a market “breathing” and not worth the distraction of viewing.
What is just important to point out is that such behavior — and divergence in particular — happens on the Weekly charts also — the begining of 2009 in GBPUSD being an excellent example — and can be a very telling indicator of future price action.
Jay Norris
www.trading-u.com
DISCLAIMER: Forex (off-exchange foreign currency futures and options or FX) trading involves substantial risk of loss and is not suitable for every investor. The value of currencies may fluctuate and investors may lose all or more than their original investments. Risks also include, but are not limited to, the potential for changing political and/or economic conditions that may substantially affect the price and/or liquidity of a currency.