I would like to share with you a method I have recently developed that allows one to take advantage of the powerful nature of divergences. If you are not familiar with this concept, I highly recommend www.babypips.com to further your knowledge.
This is a method, and not a system. The reason being is that there is discretion involved in a few key areas, however there are parameters to the method that keep the trader within his bounds. This is a method designed to let your winners run and cut your losses short.
Where is the discretion?
First, spotting divergences takes practice. It will take much effort in the beginning to learn to spot them, but once you are able, they become easy to find. To have a divergence means you are using an oscillator that shows overbought and oversold conditions. Which oscillator you choose to use is up to you. In all of my charts you will see my preferred oscillator combination...
OsMA(12,26,9) is my primary, and Stochastics (5,3,3) is my secondary. I keep them both in the same window which allows me to see the two superimposed. You may have another favorite, such as MACD or RSI. Whatever you use is fine, it will be your preference. You may notice that I have chosen two completely different periodicity settings in my oscillators which allows for slightly different perspectives on the same price information.
For this method, if the divergence is occurring on the Weekly chart, I will use the Daily chart to look for an entry trigger. If it is occurring on the Daily, I will use the 4H for entry. If it is occurring on the 4H I will use the 15M for entry. This is as low a time frame as I go for this method. (This is a second area of discretion. You may prefer a different time frame for entry if playing the 4H. You may want to use the 1H or 30M chart for entry. It's a sensitivity issue and a risk/reward modification as you will see...)
Now, let's say you've spotted a good divergence beginning to occur and let's say it is on the Daily chart. At this point, I will turn to the moving averages to give me a trigger. I keep 3 MA's on the screen. You will recognize them as fib numbers. (Again, discretion... you might like different MA's than what I use, but the concepts are the same...)
13 EMA
21 EMA
55 EMA
So what I'll do for my Daily divergence is drop down to the 4H chart and wait for a trigger. For this example, price is moving up and I am expecting a correction downward. What I will wait for is price to CLOSE below the 13 EMA (or the 21 or the 55... again discretion, risk/reward...). Which EMA you choose is up to you, but the key is to be patient and WAIT for a close below at least the 13EMA. If you use the 21 or 55 you'll have a more likely winner of a trade, but you'll have left some pips on the table.
Next, we turn to Fibonacci retracements for our stops and targets. It will become apparent on my charts, but I draw the Fibs using the beginning of the move that started the divergence pattern. The key to this system is the observation that once a divergence occurs and a correction happens, you will most likely see price hit the 23.6% line. It many times will hit the 38% line and sometimes the 50% line.
Once you've entered the trade, your stop becomes just above the 0% line, and you have 3 units on the table. Take Profit 1 is at the 23.6 line. Once you hit this, move the other two units to B/E +10 (or whatever else suits you, but don't lose anything at this point). You then let the trade run until you are stopped out (still in profit) or you hit TP2 at the 38% line. You may choose to manually close your other two units if Price Action (see james16) indicates a reversal, or you may just tighten your stop a bit more to lock in more profits. You might also decide to close out if price closes back above the 55EMA. It doesn't matter what you do at this point so long as after your first TP level is hit, you go into major protective mode. You may not want to use a 3rd unit, but if you do, then of course the 50% line is your ultimate goal.
If your trade gets stopped out, you may just be seeing another wave of divergence occurring, strengthening the pattern, or maybe the whole pattern is blown. What's important is that you are out of the market with your money safe and you can re-analyze and wait to see how much higher price goes and if the oscillator is still diverging. If you feel that the divergence has continued and strengthened, then simply repeat the process from above, dropping down to your entry time frame and waiting for a close below your trigger EMA, redraw your fibs with the new high and set your new targets.
I will now post a couple of charts to drive home these concepts...
This is a method, and not a system. The reason being is that there is discretion involved in a few key areas, however there are parameters to the method that keep the trader within his bounds. This is a method designed to let your winners run and cut your losses short.
Where is the discretion?
First, spotting divergences takes practice. It will take much effort in the beginning to learn to spot them, but once you are able, they become easy to find. To have a divergence means you are using an oscillator that shows overbought and oversold conditions. Which oscillator you choose to use is up to you. In all of my charts you will see my preferred oscillator combination...
OsMA(12,26,9) is my primary, and Stochastics (5,3,3) is my secondary. I keep them both in the same window which allows me to see the two superimposed. You may have another favorite, such as MACD or RSI. Whatever you use is fine, it will be your preference. You may notice that I have chosen two completely different periodicity settings in my oscillators which allows for slightly different perspectives on the same price information.
For this method, if the divergence is occurring on the Weekly chart, I will use the Daily chart to look for an entry trigger. If it is occurring on the Daily, I will use the 4H for entry. If it is occurring on the 4H I will use the 15M for entry. This is as low a time frame as I go for this method. (This is a second area of discretion. You may prefer a different time frame for entry if playing the 4H. You may want to use the 1H or 30M chart for entry. It's a sensitivity issue and a risk/reward modification as you will see...)
Now, let's say you've spotted a good divergence beginning to occur and let's say it is on the Daily chart. At this point, I will turn to the moving averages to give me a trigger. I keep 3 MA's on the screen. You will recognize them as fib numbers. (Again, discretion... you might like different MA's than what I use, but the concepts are the same...)
13 EMA
21 EMA
55 EMA
So what I'll do for my Daily divergence is drop down to the 4H chart and wait for a trigger. For this example, price is moving up and I am expecting a correction downward. What I will wait for is price to CLOSE below the 13 EMA (or the 21 or the 55... again discretion, risk/reward...). Which EMA you choose is up to you, but the key is to be patient and WAIT for a close below at least the 13EMA. If you use the 21 or 55 you'll have a more likely winner of a trade, but you'll have left some pips on the table.
Next, we turn to Fibonacci retracements for our stops and targets. It will become apparent on my charts, but I draw the Fibs using the beginning of the move that started the divergence pattern. The key to this system is the observation that once a divergence occurs and a correction happens, you will most likely see price hit the 23.6% line. It many times will hit the 38% line and sometimes the 50% line.
Once you've entered the trade, your stop becomes just above the 0% line, and you have 3 units on the table. Take Profit 1 is at the 23.6 line. Once you hit this, move the other two units to B/E +10 (or whatever else suits you, but don't lose anything at this point). You then let the trade run until you are stopped out (still in profit) or you hit TP2 at the 38% line. You may choose to manually close your other two units if Price Action (see james16) indicates a reversal, or you may just tighten your stop a bit more to lock in more profits. You might also decide to close out if price closes back above the 55EMA. It doesn't matter what you do at this point so long as after your first TP level is hit, you go into major protective mode. You may not want to use a 3rd unit, but if you do, then of course the 50% line is your ultimate goal.
If your trade gets stopped out, you may just be seeing another wave of divergence occurring, strengthening the pattern, or maybe the whole pattern is blown. What's important is that you are out of the market with your money safe and you can re-analyze and wait to see how much higher price goes and if the oscillator is still diverging. If you feel that the divergence has continued and strengthened, then simply repeat the process from above, dropping down to your entry time frame and waiting for a close below your trigger EMA, redraw your fibs with the new high and set your new targets.
I will now post a couple of charts to drive home these concepts...
