Divergences are one of my favorite trading concepts because they offer very reliable high-quality trading signals when combined with other trading tools and concepts.
Although indicators are somewhat lagging – a bit like price action is lagging too – when it involves divergences, this lagging feature is really getting to help us find better and more reliable trade entries. Divergences can’t only be employed by reversal traders but also trend-following traders can use divergences to time their exits.
A divergence forms on your chart when price makes a better high, but the indicator you’re using makes a lower high. When your indicator and price action are out of sync it means that something is happening on your charts that require your attention and it’s not as obvious by just looking at your price charts.
A divergence exists when your indicator does not agree with price action. Granted, this is often very basic and that we will now explore more advanced divergence concepts and see the way to trade them, but it’s important to create a solid foundation.
Divergences work on all indicators. The RSI compares the average gain and the average loss over a certain period. So for example, if your RSI is set to 14, it compares the bullish candles and the bearish candles over the past 14 candles. When the RSI value is low, it means that there were more and stronger bearish candles than bullish candles over the past 14 candles; and when the RSI is high it means that there were more and larger bullish candles over the past 14 candles.