Divergence
This is a EURUSD Daily chart with three examples of divergence to illustrate the concept.
I've used a Commodity Channel Index on this chart, when I first learned about Divergence years ago, it was with a Stochastic. Relative Strength Index can be used in the same way but for me, it's either the CCI or Stochastic.
Positive Divergence : where price makes a LOWER Low, but the indicator makes a HIGHER Low. This a bullish sign so we look to go long.
Negative Divergence : where price makes a HIGHER High, but the indicator makes a LOWER High. This is a bearish sign so we look to go short.
The example in red is a Bearish Continuation set up. Price makes a Lower High but the indicator is showing Higher High. It's an exhaustion move into a Supply Zone, great selling opportunity.
The example in blue, shows Positive Divergence. Note that price went Overbought well and truly before price tested the Demand zone, stalled and then a sharp move down, creating a FALSE BREAK of the previous low. Then it reverses and starts a significant move up. The idea here is that rather than setting a buy limit order at the zone once the indicator goes oversold, we wait for price to push down as the indicator turns up and forms a higher low. Entry can be set once we see the indicator moving higher or, wait for the false break to close and then set a buy limit order at the new zone and hopefully get triggered on the first test of that new zone.
The example in Magenta shows Negative Divergence. Higher High on price, Lower High on the CCI, this is once again, an exhaustion move up into Supply. Price goes oversold well before the zone is tested, moves higher and in this instance, pulls back then runs up into Supply.
Same chart but this time I've added the Supply Zones. I also wanted to show how price can go overbought or oversold a long time before it tests a zone or level, therefore it's important to be patient and just allow a move to play out. The signal to act comes from the indicator setting the next low or high.
Another three examples. Red shows an extended period of buying even after the CCI touched oversold. At the highs, price tops out and cannot push any higher. The attempt to false break the previous high fails with the indicator showing a sharp push up to oversold before selling off. A good indication the bulls are weak and to take profits.
Blue : this is a Continuation Short signal. Lower High on price, Higher Low on the CCI. Price is into Supply so a solid opportunity to short.
Magenta : strong positive divergence at Demand. This would be one of those mid trend zones that you could take with a reasonable amount of confidence when you see price stall above the zone and the indicator going oversold then, starting to climb. This is an indication that buyers are coming into the market.
This a Bullish Continuation. Higher Low on price, lower low on the CCI. Ideally we would like to see price coming down to test a Demand zone but in the instances such as this when it doesn't make it, we can at least take the reversal and not be left behind.
This is an H4 bearish continuation sequence. Lower High on price, Higher High on the CCI is the signal to look for a short into Supply or, take the first zone that forms on the reversal.
A bullish continuation setup at demand on the EURUSD H4.
I thought that I'd put this up because it shows the difference using divergence can make when trying to identify overbought and oversold trade opportunities.
Starting from the left of the indicator, the extremely oversold signal resulted in a false move up, then price rolled over and continued lower.
Then there's a false signal with positive divergence, followed by a false break of support and a trip into oversold forming a Lower Low on the indicator which says No Trade.
Another false move up then a move back down, false break of the previous low, positive divergence on the indicator and a sustained move higher.