DSS Divergence Forex Trading Strategy

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DSS Divergence Forex Trading Strategy

Divergence trading is one of trading’s hidden gems. Many newbie traders overlook this as it is not the most popular trading fad nowadays. But divergence trading, although it is not perfect, with the right oscillating indicator and the right strategy and filters, have been proven by many traders to yield a positive result on a trading account.

What is Divergence Trading?

Divergence is basically the discrepancy between the oscillation of an indicator and the movement of price as it forms its peaks and troughs.

As price moves along the price chart, it gyrates up and down, forming peaks and troughs. These peaks and troughs, also known as swing highs and lows, could be compared to the previous highs and lows. It could either be forming higher highs or low, or lower highs or lows. This is often how price action traders determine a trending market structure, by comparing highs and lows in relation to the previous highs and lows.

However, these peaks and troughs don’t only occur in price. Oscillating indicators also have it. This is because indicators are derived from price movement and as a result would often print an oscillation that reflects price movement. However, because oscillators are just derived price and are not price itself, they could also differ in oscillation depths and heights compared to price. This is when divergence occurs. It is when price forms a higher high or low, or lower high or low, while the oscillating indicator prints a lower high or low, or higher low or high.

To make it easier to understand, below is a cheat sheet of the types of divergences.

Forex Trading Strategy Concept

As said earlier, trading divergences is highly dependent on the type of oscillating technical indicator you are using. This is because the indicator should sufficiently be mirroring price action, while at the same time limiting false signals.

For this strategy, we will be using the Robby DSS custom technical indicator as the basis for our divergence trading. This particular indicator is relatively smooth compared to other oscillating indicators and produces lesser whipsaws and false signals. It is a tad slower than the standard parameters of the Stochastic Oscillator while is at the same time a bit faster than the MACD. One of its advantages is that it has an overbought and oversold territory, which could serve as an additional filter for the trades we could take.

We will still be using an Exponential Moving Average (EMA) band, which also serves as a trend direction indicator. We will be defining trend based on which direction the EMAs are stacked. This trend direction feature will also serve as a filter as we will be taking trades only in the direction of the trend. At the same time, it also serves as a visual indicator of the area where we could expect price to bounce. This is because EMAs are prime areas for dynamic supports and resistances. After a thrust, it is usually the area where price is pulled to, and after the pullback, it is often the area where price would bounce off from.

Although this strategy could be done as a day trading strategy, it usually has better results as a longer-term day trade or a swing trade. The 1-hour chart is usually the sweet spot as it gives a good balance of the number of opportunities presented while still giving good quality entry signals.

Indicator:

  • Robby DSS Forex: standard parameters
  • 25 EMA: gold
  • 60 EMA: green
  • 100 EMA: brown

Timeframe: 1-hour, 4-hour and daily charts

Currency Pair: any

Trading Session: any

Buy (Long) Trade Setup Rules

Entry

  • The EMAs should be stacked in the following order
    • 25 EMA: top
    • 60 EMA: middle
    • 100 EMA: bottom
  • A bullish divergence should be identifiable based on the peaks and troughs of price and the Robby DSS indicator
  • The Robby DSS indicator should have touched the oversold territory below 20
  • Enter a buy market order on the close of the candle corresponding to the change in color of the Robby DSS indicator from red to blue

Stop Loss

  • Set the stop loss at the swing low or fractal below the entry candle

Take Profit

  • Option 1: Set the target take profit at 2x the risk on the stop loss
  • Option 2: Set the target take profit at the swing high on the previous peak

Sell (Short) Trade Setup Rules

Entry

  • The EMAs should be stacked in the following order
    • 100 EMA: top
    • 60 EMA: middle
    • 25 EMA: bottom
  • A bearish divergence should be identifiable based on the peaks and troughs of price and the Robby DSS indicator
  • The Robby DSS indicator should have touched the overbought territory above 80
  • Enter a sell market order on the close of the candle corresponding to the change in color of the Robby DSS indicator from blue to red

Stop Loss

  • Set the stop loss at the swing high or fractal above the entry candle

Take Profit

  • Option 1: Set the target take profit at 2x the risk on the stop loss
  • Option 2: Set the target take profit at the swing low on the previous trough

Conclusion

Divergence trading is a great type of strategy that has already been proven to work by many forex traders. It is not perfect, but it does yield great results. Some traders who use divergence have an accuracy of around 60% – 70% win rate.

The key to making this strategy profitable is on identifying the characteristics of a profitable is on optimizing the entries and exits. There are times when although the win rate is positive, the reward-risk ratio would suffer. This is the case when the exit is based on a tight trailing stop loss and a wide initial stop loss. Often profitable trades are stopped out on a minimal profit while losing trades are stopped out on the full risk on the initial stop loss. Forward test and tweak where needed and make it your own.

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