Momentum Divergence Forex Day Forex Trading Strategy

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Momentum Divergence Forex Day Forex Trading Strategy

Reversal trading is probably one of the more difficult types of strategies. It is so hard to time when price would reverse, some would liken it to catching a falling knife. But there are traders who trade reversals as their bread and butter. It makes you wonder how they were able to predict when price would reverse and enter the trade just at the right time. Well, there are many ways to do that.

Divergences as Reversal Indications

One of the ways to anticipate a probable reversal is by trading divergences. But what is a divergence? Divergence is simply the discrepancy between price action movement and an oscillating indicator’s movement. As price moves up and down the chart, it forms peaks and troughs. These peaks and troughs are commonly known as swing highs and swing lows among price action traders. These swing highs and swing lows would then be assessed as higher highs, higher lows, or lower highs and lower lows, depending on its location in relation to the previous swing point. As price moves along the chart forming swing highs and swing lows, oscillating indicators also usually track price’s movements and forms its own peaks and troughs on its own window. However, there are times when an indicator and price disagree with each other. Sometimes price would form a higher high but the oscillating indicator forms a lower high, or price forms a lower low but the oscillating indicator forms a higher low. These discrepancies are what we call divergences.

There are several forms of divergences. Below is a cheat sheet showing what divergences look like.

Trading Strategy Concept

This strategy basically revolves around the concept of divergences using the Momentum indicator. The momentum indicator is a type of oscillating indicator that is unbounded. This means that it has no fixed range that restricts its oscillation. It could move away from the midpoint as far as it wants to. Because of this, divergences don’t tend to occur too often because it could freely track price movements without the limit of a range. So, if a divergence does occur, it tends to have a higher probability.

The settings of the momentum indicator used seem more suitable on the lower timeframes, specifically the 5-minute to 15-minute charts. If on the MT5 platform, the 10-minute chart also seems to be a perfect fit. With this said, this would strictly be a day trading strategy that would try to catch short-term reversals.

Any of the above type of divergence does seem to work. However, hidden divergences seem to have higher probabilities probably because it is usually in line with a longer trend.

Indicators

  • Momentum
    • Period: 6

Currency Pair: major pairs and pairs with enough volatility

Trading Session: Tokyo, London and New York

Timeframe: 5-minute, 10-minute (MT5) and 15-minute charts only

Buy (Long) Trade Setup

Entry

  • The momentum indicator should be below the midpoint (100)
  • A bullish divergence should be observed
  • Optional: Bullish reversal candlestick patterns could add confirmation
  • Enter a buy market order at the confluence of the above rules

Stop Loss

  • Set the stop loss several pips below the swing low (not too tight)
  • Optional: use a multiple of the Average True Range (ATR) as a cushion below the swing low

Take Profit

  • Set the take profit target at 2x the risk on the stop loss

Sell (Short) Trade Setup

Entry

  • The momentum indicator should be above the midpoint (100)
  • A bearish divergence should be observed
  • Optional: bearish reversal candlestick patterns could add confirmation
  • Enter a sell market order at the confluence of the above rules

Stop Loss

  • Set the stop loss several pips above the swing high (not too tight)
  • Optional: use a multiple of the Average True Range (ATR) as a cushion above the swing high

Take Profit

  • Set the take profit target at 2x the risk on the stop loss

Conclusion

This strategy’s bread and butter is the short-term reversals of price. This is very suitable with the momentum indicator particularly with such a short period because its reversals are very responsive, allowing us to enter the trade early.

However, because of this responsiveness and because we are trading a form of a reversal strategy, price has the tendency to overshoot our entry points before reversing. This is the reason why we should not tighten the stop loss too much when using this strategy. This would allow price to have some wiggle room if it overshoots our entry points a bit before it reverses.

Also, we are using a fixed 2:1 reward-risk ratio. This is to compensate for the losses that may occur. However, you might also observe that at times price would continue much further than our take profit target price. You may use variations of the exit if you prefer. You could either take out a portion on the take profit target and trail the stop loss for the remaining position, or you could use an exit that is totally based on a trailing stop. This would allow you to squeeze out as many pips as possible on the winning trades that starts to trend. The disadvantage of this though is that you might not be able to catch all the high yielding winning trades that should cover for some of the losses.

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