Technical STraTegy Hidden Divergence In The Forex ... - FXstreet.com

1 SFOmag.com
The Official Advocate for Personal Investing
Originally published June 2010. SFO magazine.
Technical sTraTegy
hidden divergence in The Forex MarkeT
By James Chen, CMT
Price-oscillator divergences represent some of the
most prevalent, high-probability trading opportunities
available in forex and other financial markets.
These regularly occurring chart signals should be
heeded for their capacity to warn of either price
momentum changes or trend continuations.
BackgroUnd
Divergences occur when there is an imbalance
between price action and an oscillator, which is a
mathematical derivative of price. Examples of common
oscillators include: stochastics, relative strength
index (RSI), moving average convergence divergence
(MACD), MACD histogram, rate of change (ROC),
Commodity Channel Index (CCI) and many others.
Under normal circumstances without divergence, an
oscillator that measures momentum should follow price.
The extremes (peaks and valleys) in both price and the
oscillator should be in relative agreement. Higher highs,
higher lows, lower highs and lower lows on the oscillator
should correspond with those of price action.
Once divergence occurs, however, the indication
is that price and the oscillator disagree with regard
to momentum. This temporary aberration can be a
significant indication of events to come.
Every technical trader should be aware of two
types of divergence. Regular divergence indicates
the potential for a reversal in current
momentum, resulting in a possible trend change.
Conversely, hidden divergence indicates the potential
for continuation of the current trend momentum.
higher odds
As regular divergence is more well-known, in this column
I only discuss the lesser-known type: hidden divergence.
Many traders believe that of the two types of
divergences the hidden variety is a higher-probability
potential trading setup. This is due to the fact
that hidden divergence is an indicator of potential
trend continuation as opposed to a potential reversal
indication.
Trading with the trend is considered by many
technical analysts and traders as a higherprobability
type of trading than attempting to pick
tops and bottoms, which is essentially the type of
trading approach encouraged by regular divergence
signals.
Like regular divergence, hidden divergence is
a technical imbalance between price movement
and oscillator movement. But instead of signaling
a potential reversal, hidden divergence is used
primarily to signal a possible continuation in the
prevailing trend.
BUllish and Bearish signals
Two basic manifestations of hidden divergence occur.
As shown on Figure 1, bullish hidden divergence
usually happens during uptrends and is characterized
by price making a higher low while the oscillator
makes a lower low. In this case, price and the
oscillator diverge in their signals. The net signal that
should be taken is for a potential continuation of the
higher lows in price, which is essentially a continuation
in the prevailing uptrend.
In contrast, bearish hidden divergence usually
occurs during downtrends and is characterized
by price making a lower high while the oscillator
makes a higher high. Once again, price and the
oscillator diverge in their signals. The net signal
is for a potential continuation of the lower highs

2 SFOmag.com
Figure 1: Bullish Hidden Divergence
in price, essentially a continuation of the prevailing
downtrend.
The Trade
Once an instance of hidden divergence occurs, cues
can be taken from other technical indicators to enter
a trade in the direction of the trend.
One of the best ways to enter a trade after a
hidden divergence signal involves waiting for
a breakout of a key support or resistance level
or countertrend trendline in the direction of the
prevailing trend. Supported by hidden divergence,
higher low
lower low
Source: FX Solutions—FX AccuCharts
these trend-following breakouts often carry a
higher probability of success than if divergence
were absent.
James Chen, CTA, CMT, is chief technical strategist
at FX Solutions, a leading forex broker. He is also a
registered Commodity Trading Advisor and Chartered
Market Technician. Chen is the author of Essentials of
Foreign Exchange Trading and Essentials of Technical
Analysis for Financial Markets.
Copyright 2011 by Wasendorf & Associates Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form by any means,
electronic or mechanical including posting to another website, photocopying, recording or by any informative storage and retrieval system without the written
permission of Wasendorf & Associates Inc.’s President.
This article is strictly the opinion and conjecture of its writers and is intended solely for informative and educational purposes and is not to be construed, under
any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade in any commodities or securities herein named. This article
is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Information is obtained from sources
believed to be reliable, but is in no way guaranteed. Further, there is no guarantee of any kind that is implied or possible where projections of future conditions
are attempted. The publisher is not liable for typographical errors.
Commodity futures, securities, options and forex trading involve risk and are not suitable investments for everyone. Any investment should be carefully
considered in light of an investor’s personal financial objectives and risk tolerance.
The article contained herein may provide hypothetical or simulated performance results. Hypothetical or simulated performance results have certain
inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been
executed, the results may have over- or undercompensated for the impact, if any, of certain market factors such as the lack of liquidity. Simulated trading
programs are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely
to achieve profits or losses similar to those shown. Further, past performance does not guarantee future results.