Learning how to identify divergences can be a handy advanced trading tool, as it is often used to predict reversals or continuations in price action. Looking at divergences means watching the highs or lows of the currency pair and comparing it to the highs and lows of the oscillator. The kinds of divergences can be grouped into four main ones.
The first kind is the regular bullish divergence. This is formed when price makes lower lows while the oscillator makes higher lows, and is useful in pinpointing reversals. Price makes lower lows when it is in a downtrend but the formation of higher lows in stochastic suggests that a new trend is about to take place.
The second kind is known as the regular bearish divergence. The opposite of the bullish divergence, it is used to signal a reversal in the ongoing uptrend. This takes place when price makes higher highs but the oscillator draws lower highs. This indicates that sellers have gathered enough energy to push the pair out of its current uptrend.
Third is the hidden bullish divergence. This takes place when the currency pair draws higher lows while the oscillator sketches lower lows. It is used in predicting a possible continuation of the current trend. Price has higher lows during and uptrend and a lower dip by the oscillator reflects more buying energy to take the pair higher.
The last kind is known as the hidden bearish divergence. The opposite of the bullish divergence, it is used to predict a continuation of the current downtrend. This happens as price makes lower highs while stochastic has higher highs, indicating that sellers have enough fuel to push the pair lower.
There are some conventions when identifying divergences but this depends on how strict you are with price signals. Highs in the oscillator are typically marked as the peaks but stricter traders want the oscillator to be above 80 to be considered a high. On the other hand, lows are marked as troughs but stricter traders want it to be below 20 to be considered a low.
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