Divergence is one of the most powerful trading signals provided by a range of momentum-based indicators. Unlike trend-based indicators, such as moving averages, momentum-based indicators do not lag behind the movements of the forex markets but can provide signals which predict the near-term movement of prices. Many traders will be familiar with two moving averages crossing over one another signalling a possible entry, and many will also recognise that this signal often occurs once price has already moved substantially higher or lower. On historical charts many trend-based strategies such as this look highly reliable but in real time it can be difficult to enter a trade early due to the fact that trend-based indicators require the close of the current bar in order to update.
Momentum indicators and predicting future price movements
Momentum based indicators include popular oscillators such as the Moving Average Convergence Divergence (MACD) indicator as well as the Stochastic and Relative Strength Indicators. These indicators broadly measure the momentum in the market by focusing on the relative changes in the closing price of a forex pair in order to determine the strength of buying or selling of the pair. The indicators fluctuate between an upper, overbought and a lower, oversold zone on the indicator window. One of the major advantages of using these momentum indicators is that they are effectively measuring market sentiment and can tell traders before the event when markets are looking set to reverse or if a correction may be imminent.
Forex trading using more than one entry signal
Momentum indicators, like trend-based indicators, do not provide a precise entry for forex traders and it is not advised to take trades simply when an indicator such as the Stochastic oscillator shows that a currency pair is overbought or oversold. However, as an improvement to a lagging indicator, this situation should be used by trades to prepare for an additional indication that price is about to move in the opposite direction and allow time to enter the trade as early as possible. The reliability of these momentum indicators is very high as demonstrated by any price chart on all timeframes. When price moves in to either the oversold or overbought zones on the popular momentum indicators, it invariably reverses or forms a correction shortly afterwards. There is, however, also the possibility that price can remain in the overbought of oversold zones for significant amounts of time which is why momentum indicators should not be taken as lone signals to trade forex.
Divergence as a powerful use of momentum indicators
Another highly popular feature of momentum indicators is their ability to show when market price ‘diverges’. Divergence is a highly reliable and very popular method of trading when price is in either the overbought or oversold areas on an indicator. It occurs, in its regular form, when price moves higher or lower relative to a recent price movement, but the value on the indicator shows an opposing lower-high or higher-low. This is interpreted by traders as the market price of a currency pair being artificially high or low relative to the underlying market momentum and is a strong sign that a reversal is likely to occur in the very near future. One particularly effective forex trading strategy using divergence is to look for divergence within thin the overbought or oversold zones of a momentum indicator which also coincides with a key psychological level of support or resistance. Many traders apply pivot points, Fibonacci or previous reversal levels to their charts to spot where this divergence has the highest probability of success.
Combining trend and momentum indicators
Some forex traders prefer to combine both trend-based indicators and momentum indicators to spot trading opportunities. This can be through applying a popular moving average, such as the 100 or 200 MA, to a forex chart in order to establish the direction of the trades that they are willing to take using a momentum indicator. Most traders will agree that trading in the direction of the underlying, longer-term trend will increase the chances of trading success. By only taking overbought setups below and oversold setups above the moving average, the probability of a successful trade is reinforced by agreement between both trend and momentum indicators.