Convergence as Confirmation of Trade Signals

Best Binary Options Brokers 2020:
  • BINARIUM
    BINARIUM

    Top Binary Options Broker 2020!
    Best For Beginners!
    Free Trading Education!
    Free Demo Account!
    Get Your Sign-Up Bonus Now:

  • BINOMO
    BINOMO

    Only For Experienced Traders.

Convergence As Confirmation

Convergences are a powerful indicator for traders of all varieties. Convergences, as the name suggests, are when two or more indicators or other analysis devices are leading you down the same path. Imagine a stream flowing down a valley. It meanders along on its own, following the trend of elevation until it joins, or converges, with another stream. Together these two streams become a river that flows down the mountain, also following the trend until it converges with yet another river becoming a much stronger and larger river. If you can think of an indicator, and by extension the traders who follow an indicator, as a river of money then it won’t be hard to imagine two indicators in convergence as two rivers of money becoming one much larger and liquid river. The more indicators that converge together the more traders who are following the same signal making it more powerful than other lesser signals. Most strategies utilize some form of convergence and confirmation in order to trigger.

Convergence of indicator with price action. This is the simplest of all convergences but perhaps the most important to watch for as it can impact a trend following or contrarian strategy. A convergence of indicator with price action means that as prices make a new high the indicator makes a new high as well. The same is true for new lows in a down trend. This type of convergence most commonly occurs with oscillators such as MACD, stochastic and RSI but can also be useful with moving averages and other types of tools. This type of convergence reveals strength in the underlying trend and means that prices are much more likely to continue higher or lower than they are to reverse. Think about it like this; the indicator measures the strength of the underlying market, if the market makes a new high and the indicator makes a new high it confirms increasing strength in the market and the underlying trend. Look at the chart below. Price action makes a new high that is confirmed by a high in the MACD. Prices correct temporarily but continue higher after reaching the trend line.

Convergence of indicators. From time to time indicators will converge as well. Usually this happens within a couple of days of each other and is usually referred to simply as a “confirmation” as in one indicator confirmed another. This can be when stochastic makes a bearish crossover at the same time MACD and/or RSI falls below the center line. This type of convergence is very useful for momentum and short term traders as it can often precede a rapid movement in the stock. Lot of traders use the individual buy and sell signals given off by trend following indicators, the more indicators confirming a signal at one time the more likely a sharp move is on the way. Look at the chart above. To the right side is marked an area where prices are being supported by the trend line. Then we get a convergence of trend following signals including MACD, stochastic and the moving average that lead to another move higher.

Convergence of time frames. All too often a good signal fails because time frames were not considered. It is possible for a trend in one time frame to overpower a trend in another the way one incoming wave overpowers another as the tide rolls in. A convergence of time frames is when the underlying trend in one time frame matches that of a shorter or longer time frame. For example if an asset is moving higher on a stochastic crossover on the charts of weekly prices a similar bullish crossover on the daily charts has a much higher chance of profitability than a bearish one. This is simply trading with the trend and a powerful confirmation of trade signals. The chart below is a longer term chart of the same asset shown above. Notice how the MACD on this chart confirms price action and the daily chart, leading to a prolonged up trend in the asset.

Convergence of Indices. The market is a vast place filled with many types of stocks, commodities, currencies and etc. The indices were created to follow different portions of the market. The S&P 500 measures the broad market of large companies. The Russell’s measure small businesses, the Dow Transports measure transportation related stocks and the Nasdaq is filled with technology related companies. Because there are different reasons to be in one type of stock or another and those reasons change from time to time it is rare for the indices to be in tandem, even when they are all trending higher. A convergence of indices is when two or more of the major indices are in tandem and could lead to a big move in all stocks.

Convergence With Index. This is when an individual stock is trading in tandem with the underlying index. For example Apple and the Nasdaq. If price action and indicators for Apple are convergent with the indicator on the Nasdaq there is a stronger chance of the signal paying off than if the two were at odds with each other. In this way the underlying market sector and the individual stock are confirming each other. A good way to find lots of high probability trades is to wait for a signal on an index and then scan the underlying stocks for similar signals.

These types of convergence are not only powerful confirmations of signals they are also great ways to find trades. Once you begin to recognize them with confidence you can then look for them on any chart or time frame you choose. In fact, I highly recommend using these techniques any time you are entering a trade. Once you identify a signal look for some convergences. Are there any to help confirm your original signal or do they tell a different story?

How To Trade A Divergence – A Step By Step Divergence Trading Guide

How To Trade A Divergence – A Step By Step Divergence Trading Guide

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 – just like price action is lagging too – when it comes to divergences, this lagging feature is actually going to help us find better and more reliable trade entries as we will see below. Divergences can not only be used by reversal traders but also trend-following traders can use divergences to time their exits.

InВ my own trading strategy, divergences are a big part for one of my setups and in combination with other signals. I do not recommend trading divergences by themselves but they are a good starting point.

What is a divergence?

Let’s start with the most obvious question and explore what a divergence really is and what it tells you about price. You’d be surprised how many people get this wrong already.

A divergence forms on your chart when price makes a higher high, but the indicator you are 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.

Best Binary Options Brokers 2020:
  • BINARIUM
    BINARIUM

    Top Binary Options Broker 2020!
    Best For Beginners!
    Free Trading Education!
    Free Demo Account!
    Get Your Sign-Up Bonus Now:

  • BINOMO
    BINOMO

    Only For Experienced Traders.

Basically, a divergence exists when your indicator does not “agree” with price action. Granted, this is very basic and we will now explore more advanced divergence concepts and see how to trade them, but it’s important to build a solid foundation.

Bearish and bullish divergence. Price and indicator are out of sync. Divergence foreshadows reversal.

An RSI divergence

#1 Revisiting the RSI

Divergences work on all indicators, but my favorite by far is the RSI (Relative Strength Index). 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.

#2 When does an RSI divergence form?

Understanding when your indicator is high or low is important when it comes to interpreting divergences and I generally encourage traders to look beyond the squiggly lines of their indicators to explore what it really does.

During trends, you can use the RSI the compare the individual trend waves and so get a feeling for the strength of the trend. Here are the three scenarios and the screenshot below shows every single one:

(2) Typically, the RSI makes higher highs during healthy and strong bullish trends. This means that there were more and larger bullish candles in the most recent trend wave than there were compared to the previous wave.

(1) When the RSI makes similar highs during an uptrend it means that the momentum of the trend is unchanged. When the RSI makes an equal high, it does not qualify as a divergence because it just means that the strength of the uptrend is still up and stable. Higher highs on the RSI do not show a reversal or weakness. It just means that the trend is progressing unchanged.

(3) When you see that price is making a higher high during a bullish trend, but your RSI makes a lower high, it means that the most recent bullish candles were not as strong as previous price action and that the trend is losing momentum. This is what we call a divergence and in the screenshot below, the divergence signaled the end of the uptrend and it makes a downtrend possible.

#3 Conventional technical analysis is flawed

Classic technical analysis tells us that a trend exists when price makes a higher high – but like too often, conventional wisdom is seldom right and usually simplifies things too much. A trader who only relies on highs and lows for his price analysis often misses important clues and does not fully understand market dynamics. Even though a trend could look “healthy” at first glance (higher highs and higher lows), it might be losing momentum at the same time when we look deeper at the candles and the momentum.

Spotting a divergence on your momentum indicator, thus, tells you that the dynamics in the trend are shifting and that, although it could still look like a real trend, a potential end of the trend could be near.

How to trade a divergence – the optimal entry

A divergence does not always lead to a strong reversal and often price just enters a sideways consolidation after a divergence. Keep in mind that a divergence just signals a loss of momentum, but does not necessarily signal a complete trend shift.

To avoid trade entries that don’t go anywhere, I highly suggest you add other criteria and confirmation tools to your arsenal. A divergence alone is not something that strong enough and many traders experience bad results when trading only with divergences. Just like any trading strategy, you need to add more confluence factors to make your strategy strong.

Below we see how price made 2 divergences but price never sold off. The divergences, thus, just highlighted short-term consolidation.

Tip: Location

Location is a universal concept in trading and regardless of your trading system, adding the filter of location can usually always enhance the quality of your signals and trades. Instead of taking trades just based on a divergence signal, you’d wait for the price to move into a previous support/resistance zone and only then look for divergences and trend shifts to time entries.

TheВ screenshot below is a great example: On the left side, you see an uptrend with two divergences. However, the first one completely failed and the second one resulted in a massive winner. What was the difference? When we take a look at the higher time frame on the right we see that theВ first divergences happened in the middle of nowhere and the secondВ divergence formed at a very important resistance level (yellow line and yellow arrow). As a trader, you first identify your support/resistance zones and then let price come to you. Such an approach will impact your performance in a big way.

Divergences are a powerful trading concept and the trader who understands how to trade divergences in the right market context with the correct signals can create a robust method and effective way of looking at price.

Confirmation

What Does Confirmation Mean?

Confirmation refers to the use of an additional indicator or indicators to substantiate a trend suggested by one indicator. Since technical indicators are not perfect predictors of future price movements, a trader often feels more secure deciding to act on a signal if more than one indicator is sending the same signal. If different indicators send conflicting signals, this is known as divergence.

Key Takeaways

  • Confirmation can refer to a broker’s written acknowledgement of trade completion or the use of an additional technical indicator to substantiate a trend suggested by one indicator.
  • Two different technical indicators, such as volume or moving averages, help establish the prevalence of a trend for traders.
  • Confirmation of trends can be susceptible to confirmation bias.

Understanding Confirmation

Confirmation can also refer to a broker’s written acknowledgment that they have completed a trade. These can be in electronic or paper form, and record information such as the date, price, commission, fees, and settlement terms of the trade. Brokers typically send a confirmation within one week of the trade’s completion.

Technical indicators fall into four broad categories: trend, momentum, volatility, and volume. When seeking confirmation for a trade signal provided by one indicator, it is usually best to look to an indicator from a different category. Otherwise, the same or similar inputs are counted multiple times, giving the illusion of confirmation when in fact little new information has been taken into account.

Trend indicators include moving averages, moving average convergence divergence (MACD), and the parabolic SAR. Momentum indicators include the stochastic oscillator, the commodity channel index (CCI), and the relative strength index (RSI). Volatility indicators include Bollinger Bands, standard deviation, and average true range (ATR). Volume indicators include the Chaikin Oscillator (also used to measure momentum), on-balance volume (OBV), and the volume rate of change.

Confirmation Example

Suppose a trader notices a golden cross, which occurs when the 50-day moving average crosses above the 200-day moving average. This is a signal to buy the stock, based on a trend indicator (the moving averages). Because this signal alone does not guarantee higher prices, the trader might seek confirmation from a different type of indicator. In this case, a high trading volume would reinforce the buy signal, while lower volumes might make the trader reconsider taking a position in the stock. The OBV indicator would, therefore, be a logical choice to confirm the trade: a rising OBV would confirm the golden cross’ bullish signal, while a flat or falling OBV would suggest that the price is nearing a top.

Confirmation Bias

When seeking confirmation for a signal, investors should always be wary of confirmation bias, the tendency to set greater store by the information that agrees with preconceived notions and to discard information that clashes with those notions. Of course, different sources of information always send conflicting messages to some extent, but traders should take care not to discount mixed signals.

Best Binary Options Brokers 2020:
  • BINARIUM
    BINARIUM

    Top Binary Options Broker 2020!
    Best For Beginners!
    Free Trading Education!
    Free Demo Account!
    Get Your Sign-Up Bonus Now:

  • BINOMO
    BINOMO

    Only For Experienced Traders.

Like this post? Please share to your friends:
Binary Options Theory and Practice
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: