Using Divergences

There are several ways of using divergence, whether you use indicators or not. I like to use this definition of divergence:

“moving apart: the process of separating or moving apart to follow different paths or different courses”

When you have highly correlated pairs, they move in tandem with each other- when one moves up the other moves up. When one moves down, the other moves down. At any time, if they move in opposite directions, then you have a divergence.

They key thing here, is that there IS no leader or lagger in these scenarios (I.E cable pulling fiber or fiber pulling cable), you use divergence to spot for possible change in direction, and possible change in market sentiment. I usually only trade AUD/USD, GPB/USD, and EUR/USD, so they move up and down together due to high correlation. I use different kinds of divergence to help me get a directional bias in the market (meaning I use it to decide buy/sell, but not when).

One easy way of spotting a divergence, is paying attention to the formations of your fractals.

Fractals are just a fancy word of saying swing high/swing low, and they come as a common indicator.

When you have higher highs and lower lows, you have an uptrend. Conversely, if you have lower lows and lower highs, you have a downtrend. Due to correlation, correlated pairs will all be in a uptrend, or a downtrend.

When you see your divergence, 1 or more of your pairs will fail to form the next proper fractal in the sequence- and this is when you say “hmm… whats going on? Should I be looking to trade the other way on the other 2 pairs?”

When using Fractal divergence, I only care about if what I consider is an “important” fractal getting breached, versus some intermediate ones.

I spot for divergences in COT and Bond Yield reports as well.

The COT is the commitment of traders report (read up on it), which shows the positions of all the big and small traders in the market. Bond yield reports are well.. bond yields. Since I trade the majors, I am interested mainly in the Dollar COTs, and the Dollar bonds. I also view Cable (GPB) Fiber (EUR) and Aussy (AUD) information, as these are the charts I pay attention to.

COT Charts link:

http://timingcharts.com/charts

Under Commodity Select Dollar Index (or whatever the heck you want), and for history select a timeframe of 1 Year. What I look for on these charts is a rapid change in commercial positions, or the net positions hitting critical areas. Here is an example of a COT chart all doll’ed up for you:

By following the commercial traders, you can see that price of euro is inversely proportional to commercial trader positions, when one goes up the other goes down. I used green lines for a increased demand in euro, and red lines for a decrease. The blue circles is what I look for in terms of bias in the more macro sense- basically looking for any indications of a change in direction or strength in direction. This is typically seen as a big shift in commercial trader positions, and as you can see in the blue circles- there is a big shift typically before a big swing in the market. Pink lines are the highs and lows of the year, which you should also pay attention to. Currently euro COTS are at the highest all year, while EUR/USD has formed new lows. We will have to keep watching the cots for when you see the shift in commercials (and following it by buying more euros.)

US BOND YIELDS link:

http://stockcharts.com/freecharts/perf.html?$TNX,$UST2Y,$UST5Y,$UST10Y,$UST30Y

For this, I look for divergence between the different bond yields- failure to create new highs and lows, which suggest a change in direction.

When spotting divergence with these reports, I follow the same rules- label the important highs and lows, then watch for a breach (new highs/new lows)

4 thoughts on “Using Divergences”

  1. My brother suggested I might like this blog. He used to be totally right. This put up actually made my day. You can not believe simply how a lot time I had spent for this info! Thanks!

  2. Bennyblossom said:

    What is the indicator in the bottom chart, the one that shows the positions of the large, small and commercial trader

    • If you are talking about the picture where I put blue circles over everything, that “indicator” shows the net position of the traders. If you look at my COT Analysis page, you take that weeks net longs, subtract by the net shorts, and you have the Y- value on that indicator. So this means the more negative (lower) on that indicator, the more net short that group of traders is

      • Bennyblossom said:

        Thanks, I’ll have to look at the COTs reports, I’ve never really paid too much attention to it, but you’ve pulled together some useful data here

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