There are many divergence indicators out there, some developed for MT4 and some developed for other trading platforms. Honestly, I find them all utterly horrible. They give you a hundred and one divergence signals and more often than not, you spend your precious brain processing power filtering out the bad ones. Even worse, you trust these divergence signals, place a trade and end up losing money. What do some of these indicators look like? Here’s a picture to show you just how utterly horrible they are.
[picture of horrible divergence indicators]
Now, if you’re looking for the absolute best divergence indicator that can filter out proper divergence signals on stochastic, RSI and even MACD, you’re at the right place. Trust me, a hell lot of time was spent filtering out the bad entries so that was is presented to you in the end are only the best ones that meet our criteria.
So before we go into what criteria makes up a good divergence signal, I feel that it’s important to first know what in the world is a bullish divergence and a bearish divergence. In its most simplest terms, a divergence means a disagreement. Price thinks it is supposed to go up higher and the oscillator (RSI, MACD or Stochastic) thinks that it’s supposed to go lower – this is an example of price and oscillator disagreeing with each other. We always go with the oscillator’s direction. If the oscillator thinks the market is bullish and price thinks it should be going down, we call this a bullish divergence. If the oscillator thinks the market is bearish and price thinks it should be going up instead, we call this a bearish divergence. Always follow the oscillator.
Now, a lot of people ask me “what is the best oscillator to look for divergences in? Stochastic? RSI? MACD? TDI? Alligators? Pokemon?”. To answer this question once and for all, I feel that the only three oscillators you should consider are Stochastic, RSI and MACD. In terms of which is strongest, I personally feel that they are all strong, but together, they are stronger (cue band of brothers theme song).
Stochastic divergence? That’s cool.
Stochastic and RSI divergence? I’m losing it!
Stochastic, RSI and MACD divergence altogether?! I’m selling my house for this trade! (kidding, please don’t do that)
Anyway, here’s a simple visual example of what a bullish and bearish divergence looks like.
[picture of bullish divergence and bearish divergence]
Alright, now that you understand what exactly bullish and bearish divergences are, let’s go into criteria on what makes a good one versus what makes a bad one. You see, not all divergences are formed with equal importance. What determines how good a particular divergence is depends on how obvious it looks. If you have to squint your eyes to see a divergence pattern, it is not obvious enough and usually not very good. So to make a divergence pattern obvious, we need to have significant swing highs and lows, not those puny small ones. Since a picture speaks a thousand words, here are examples of good divergence signals using our stochastic divergence indicator, RSI divergence indicator and MACD divergence indicator. In all these examples, you will notice how nice the swing lows (for bullish divergence) and swing highs (for bearish divergence) are that triggered the divergence signals.
[picture of stochastic, RSI and MACD divergence signals for bullish and bearish]
So how do we do this in our indicator? Well, we need to define how ‘big’ the move is leading up to the swing high / swing low. To do this, we use a proprietary formula that measures the heartbeat of that particular currency pair. This is important because not every currency pair moves with the same heartbeat. Some have larger moves and some have smaller moves. The higher the heartbeat number, the stronger the move has to be over the preceding X bars that lead up to the swing high/low. The sweet spot we have discovered is usually 2.0 for this value and over 5 bars. This basically means that the total distance covered by the 5 bars leading up to our swing high/low, should at least be bigger than a heartbeat of 2.0.
Now, you can see how we’re starting to properly define how significant our swing high/lows are. It’s like we’re defining their depth. In every divergence signal generated by our MT4 divergence indicator, there are always 2 points. Point A and Point B. Point A is where the divergence begins and Point B is where the divergence ends. Point A can have the luxury of having a proper swing low/high formed but point B, which is what triggers the divergence signal, is very sensitive and tries to detect the earliest sign of a divergence signal being formed. If you reduce its sensitivity, you can catch nice divergence signals when they occur but are usually a bit late to the party, so you need to wait for price to retrace a bit more before entering in. If you increase the sensitivity, you can detect the divergence opportunity immediately when it is formed, but you risk getting in too early.
“Okay, what the hell was that block of text above, Desmond? Can you please show me a proper picture to better explain it to me?”
[pictures of different sensitivities for swing point B]
So far, we have covered how significant a swing high/low is leading up to a divergence signal and also how sensitive Point B is when detecting when the signal is triggered. Now, we will cover angle validity. I can already hear everyone’s voices going “What in the world is that?”. Fear not, I will do my best to explain what this means. Like I said, this is the best divergence trading indicator out there for good reason, it simply leaves no stone unturn in our quest to trading divergences.
Most divergence indicators out there simply draw a divergence signal line when they detect that oscillator swing low B is higher than swing low A (for bullish divergence) and oscillator swing high B is lower than swing high A (for bearish divergence). In theory, this is correct. But when you draw it out in reality, you notice that it doesn’t connect smoothly based on the angle you draw it at, largely because there’s something blocking the smooth connection of point A and B. This means that the divergence signal is invalid. As long as there is no smooth connection between two points based on the angle it is drawn from, there is no valid divergence signal. Below is an example of what this means :
[example of invalid divergence signal because line got cut in between]
You can see in the above example how between point A and B, the line was cut. Many divergence indicators out there simply use the mathematical calculation to detect these levels and as long as oscillator point B is above point A (for bullish divergence), they draw a line and think everything is fine. Is it fine? Hell no it’s not. It almost angers me that so little thought is put into filtering out these nonsensical setups.
How does our MT4 divergence indicator filter out these setups? Well remember when you told your mathematics teacher that you would never use any darn equation in your life ever? I had to call up my mathematics teacher and apologise after discovering this. We have the use the equation of a diagonal line Y=mX + C to calculate every single value of our oscillator between point A and point B and ensure it does not clash with any other lines around. This ensures that the diagonal line drawn between point A and B is uninterrupted. This is then replicated for the swing highs and lows in price too to ensure our divergence signals are beautiful when they happen.
Alright, at this point you must be like “This dude is crazy, how many other funny filters does he have for his divergence indicator?”. Well, the answer to that is : as many as it takes.
So we’ve covered the concept of angle validity when identifying divergence signals. Now, let me introduce another term to you called distance validity of the divergence signal. Is this real life? Or is this just fantasy? *cue Queen*
So, distance validity basically means if a divergence signal between point A and point B is too far apart and has too many significant swings in-between, it doesn’t make sense and should not be considered. It’s important to filter out these types of signals is our divergence trading strategy. Simply put, divergence occurs best when they occur not too far apart and without too much noise in-between. What does this mean? It is best explained in terms of a picture of course.
[Picture where point A and B are too far apart to be considered a valid divergence signal]
In the above example, we can see that the distance between point A and point B is very far apart and there are many other swing lows in-between. These types of divergence signals don’t make any sense – even just by looking at it, you know it is not a good divergence signal. This usually happens in many of the divergence indicators developed out there because there is no proper filter to detect the distance between point A and point B and also to measure the volatility between these points. I do have to warn, though, that this is easier said than done. We solve this by limiting the number of significant swings in-between point A and B and the maximum distance allowed for this to happen.