The Only 2 Types of Divergences: The Rules

This post on Divergences is VERY concise. Every sentence has actual meaning and use. “Peak” below means either peak (high) or valley (low).

A divergence is a discrepancy between market action and indicator action. There are only two types of divergences:

1. The market moves farther in a direction and the indicator does not move farther in the same direction, and
2. The indicator moves farther in a direction and the market does not move farther in the same direction.

To see a discrepancy, we have to look on the same side of the market and the indicator. So if we look on the top side of one, we must look on the top side of the other. If we look on the bottom side of one, we must look on the bottom side of the other.

The discrepancies can only occur on the top side and the bottom side of the market and indicator.

When we see a discrepancy on the top side, that is a signal that the market could move down.

When we see a discrepancy on the bottom side, that is a signal that the market could move up.

When the market moves farther in a direction and the indicator fails to move farther in the same direction, then that is a sign of weakness in the direction that the market moved. So, discrepancy (1) above is a sign of weakness in the direction that the market moved farther in.

When the indicator moves farther in a direction and the market fails to also move farther in the same direction, then that is a sign of strength in the direction such signal says the market could move. So, discrepancy (2) above is a sign of strength in the direction the signal tells us the market could make a move.

Condition one to having a signal is that there be a discrepancy between market action and indicator action. That discrepancy will always be one of the two types above, on the top or bottom.

[NOTE: A signal on a chart is meaningless outside of what is called a “line-up”. Line-ups will be covered later in the training.]

How to Determine if a Divergence Exists

To actually have a signal from a divergence,

1. one must begin at either
   • a market peak or
   • an indicator peak

   farther back in time and move toward present time (to the right on a chart).

2. From that beginning peak one draws a line from the market peak and/or indicator peak to the market’s “now” point at that time if one is drawing on charts that have already occurred.

If one is actively looking for divergence signals in real time, it is impossible to have a market peak in real time “now”.

Reason: a peak, by definition, must be beyond the previous and next bar. Since there is no next bar right now, “now” can never have a peak. Therefore, we must start at a market or indicator peak in the past. That’s condition two – the starting point of a signal must be at a market or indicator peak, and that must be left of where we are drawing to.

The Third Condition to Having a Real Divergence

Condition three to actually having a signal is that over the exact same time period from the starting point (market or indicator peak) to our “now” point, we may not draw the line through either the market action or the indicator action. On the market, the bars representing market action act as a barrier. On the indicator, the indicator line itself acts as the barrier.

When all three conditions are filled, we have a divergence signal.

If all three conditions are not filled, we do not have a signal.

IN SUMMARY: Over the exact same time period on a chart, we may not draw a line through the market or the indicator to get to our “now” point. A discrepancy (1), where the market moves farther in a direction and the indicator does not move farther in the same direction over the same time period, that shows weakness in the direction the market moved farther in.

In a discrepancy (2), where the indicator moves farther in a direction and the market does not move farther in the same direction over the same time period, that shows us strength, or coming strength, in the direction the discrepancy (2) says the market could move. All three conditions must be met to have a signal. If all three conditions are not met, there can be no signal on that chart at that time.

Please note that I have a horrible storm system just a few minutes away from me as I finish the typing. I will have a video for you showing you everything above (and probably even a little more) tomorrow.

Added 2008 June 11:

Sorry I’m not a video expert, but what the heck. I’ll get better with more practice. Leave me comments and questions and I’ll answer you!

Kick it with your own forex trading.

I hope that this helps you. Have a truly phenomenal day!
Russell