What Is a Divergence?
By now, only looking at the structure of our projects here in the Binary Options Academy and one can see that we cover from simple technical analysis concepts to more complicated ones and even touching fundamental analysis ones.
The concept of a divergence has been treated here as well so far but this educational series is about another type of divergence few know: hidden divergences and positive or negative ones.
Like any other divergence, one should have an indicator, namely an oscillator, and the purpose is to compare moves price makes with the ones being made by the oscillator and then to try to interpret them.
A divergence appears when price and oscillator, of course, are diverging, in the sense that the trader should look for different moves price and the oscillator are making and then trying to figure out which one is the real one: the one made by price or the one made by the oscillator.
This is usually being visible in the sense that market will fail to make a new high and the oscillator is doing it, or the other way around: the market makes a new high/low but the oscillator is not confirming it.
What is a Hidden Divergence?
This is a classical divergence, however, it is not the only one to be traded and by looking at the two recordings that are coming with this project one can clearly see what a hidden divergence is and how to trade binary options based on the concept.
Hidden divergences are tricky because of the simple thing that they are hidden, meaning are difficult to be spotted.
A classical divergence, like mentioned a bit earlier, is based on the differences between price and oscillator, and when the oscillator is forming a divergence that has a rising trend line as an outcome, it is said that it is a bullish divergence, while a bearish one always has a trend line that is moving to the downside, showing bearish conditions. In the first instance call options are favored, while in the second one put options.
Almost all divergences are being drawn from the top or bottom as they are being based on differences between price and oscillators. However, there are divergences that can form in the middle of the oscillator range and not at tops or bottoms.
For example, one way to identify one is to draw a line in the middle of the oscillator window and then interpret everything there and not at overbought and oversold levels.
The great way to exemplify this is to look at the RSI (Relative Strength Index). The standard interpretation of the RSI is that any values below the 30 level are considered to be in oversold territory and therefore we need to buy call options as market is supposed to reverse. That is the area where we should look for classical divergences.
Using an Oscillator
The same is valid if the oscillator is traveling above the 70 level, but this time the area is considered overbought and put options are favored.
But consider this: right click on any Metatrader window and on the Indicator tab, click the Edit button. This way we can edit the RSI, adding any level we want. By choosing the 50 level, basically the RSI window will be split into two equal parts: the lower part stretching from the 30 to 50 and the upper one from the 50 to 70.
The way to trade this type of divergence is totally the opposite of a classical one as actually we’re looking here for a continuation pattern. If a bullish divergence means that the oscillator is forming higher low while price is not confirming, in this case the oscillator should make a new low, so basically going with price. However, the key is not to break the 30-40 area and then, on any move above 50, it is the striking price for a call option. This opposite is true as well when it comes to the 70 area and put options are recommended there.
Can divergences be used with classical indicators, like trend indicators, and not with oscillators? Well, it is a very difficult thing to look for such a divergences but with some indicators it is a profitable way to trade.
Using Bollinger Bands
Using the Bollinger Bands indicator for once is possible to look for divergences and the thing to do is to look for the lower Bollinger Band to make a series of two lows and price not to confirm it. How it is possible for price not to confirm two lows? Well, in the case of Bollinger Bands this means that price is not piercing the lower Bollinger Band the second time and that it is being called a divergence.
The striking price for this divergence is when market is turning and the lower Bollinger Band turns as well on a rising path. That is considered to be the confirmation.
The same is true in a market that is rising, as the upper side of the Bollinger Band indicator is the one that is supposed to make two different highs while price is not piercing the band the second time and by the time the Bollinger Band is reversing on a downward path, put options can be traded.