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Divergences are very popular for trading as they have one excellent advantage – they are very visible which makes executing trades very simple. To identify a divergence, traders must compare an underlying asset’s price with an oscillator indicator (not a trend indicator, as this does not show true diverging moves). An oscillator will confirm the movements that the price makes and will enable divergences to appear. For a divergence to be a valid one, the moves of the oscillator and price must be compared to each other and if a difference is discovered between them, they are said to be moving divergently. It is important to note, however, that asset prices often appear to make false moves, so an oscillator should be used every time. If an oscillator is showing a rising path yet the asset’s price shows a falling path, the divergence is said to be bullish, and in that situation the trader should purchase call options. On the other hand, if the oscillator shows a falling path while the asset’s price is on a rising path, the divergence is said to be bearish and the trader should instead purchase put options. The expiry date should, of course, be set according to the time frame on which the divergence appears as well as the investor’s own individual trading plan.
Plotting An Oscillator to Find a Divergence
Usually, when looking at divergences, the trader should stick with the oscillator, as often the asset’s price will give a fake move. This is because the oscillator will be plotted by taking into account a larger number of candlesticks that have already closed and therefore a current value is shown. When a trader plots an oscillator, they are able to set the period for the oscillator to take into consideration to plot the values. So if, for example, the time frame is set to 14, this means that the oscillator takes into account the previous 14 candlesticks before plotting the current value. Price, on the other hand, refers solely to a single candlestick. It is easy to see, therefore, why the oscillator’s information is more comprehensive and more reliable, to pay attention to. Trading divergences is not as easy as it seems however, as choosing the right time frame is essential. If a divergence forms on a larger time frame such as a daily chart, choosing the correct expiry date for a binary option is tricky as there may not a an expiration date available that is big enough.
How to Trade Divergences
When trading divergences, a trader must pick a bottom or a top and this can be challenging. Choosing a top or bottom means that the trader is aware of when the market is on the turn and this is why divergences are very visible and therefore very popular with traders worldwide. The key to successfully trading divergences is to go with lower time frames, with the hourly chart being the largest time frame to use as this will mean a shorter expiry date. For example, if a trader identifies a divergence on the five minute chart, even an hourly expiry date can be difficult to trade, so they should look for a larger one even in such a short time frame. However, if the divergence is identified on an hourly chart, a trader can trade any expiry date they prefer, and if the divergence appears on the second half of a month, an end of month expiry date can also be traded. It is, however, difficult to trade longer than the end of the month as most brokers do not offer the possibility of such long expiry dates.
Trading divergences is usually very rewarding as well as pretty simple – in a bullish divergence, a trader should place call options and in a bearish one, put options should be favoured, remembering of course to use the correct matching expiry date to the time frame on which the divergence appears. If a trader manages this successfully, he should achieve good success with this method.
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Recommended readings
- An empirical examination of information, differences of opinion, and trading activity. Bessembinder, H., Chan, K., & Seguin, P. J. (1996). Journal of Financial Economics, 40(1), 105-134.
- “On divergence of opinion and imperfections in capital markets.” Mayshar, Joram. The American Economic Review 73, no. 1 (1983): 114-128.
