Using Convergence and Divergence and CCI in Forex Trading

04/14/2010 12:01 am EST

Focus: FOREX

Sam Evans

Instructor, Online Trading Academy

The concept of understanding convergence and divergence in technical analysis was one of the very first subjects I was taught in the Online Trading Academy classroom when I was a student, and to be honest, I found it a little confusing in the early stages. I was probably just going through a similar challenge that many novice traders are faced with in the early stages of their education, namely an overload of information and new ideas. This is common, so don't think you are alone if you’re currently faced with the same prospects.

As an instructor in the Online Trading Academy classroom and ongoing Extended Learning Track (XLT) environment, I tell my students that it will always serve them well to start their trading career with a simple and methodical approach, because this will give them the very best chance to gain consistency in their speculation and analysis. As they begin to master the core skills of risk management and objective analysis, they can then start to add a few extra tools to their arsenal to enhance their performance, and if used correctly, implementing convergence and divergence analysis into the trading plan can be of great use over time.

Typically, traditional methods of technical analysis use the Moving Average Convergence Divergence, or MACD, indicator for this technique, and while I would agree that this is one way of carrying out the study, it can be done with other indicators as well. This week, I will focus on using one of my preferred analysis tools, the Commodity Channel Index, or CCI, to carry out objective convergence and divergence analysis in conjunction with a solid understanding of supply and demand. But let's first come to grips with the terminology itself.

Convergence is described as when price action is generally following the same path as what we are seeing on our technical indicator. So, for example, in an uptrend where the market is making higher highs and higher lows, we would also be seeing signs of strength in our technical indicator of choice. This is a sign of continuing momentum in price and would suggest that a trend has a higher probability of continuation. The same would be said for a downtrend, but the market would be making lower lows and lower highs with weakness showing on the indicator, giving the trader clues that there is still momentum in the downside moves. Basically, price and the indicator are doing the same thing, or converging.

Divergence is described as when price action is not following the same path as what we are seeing on our technical indicator. In an uptrend of higher highs and higher lows, we would now be seeing weakness in our technical indicator of choice. This is now a sign that momentum is beginning to decrease, suggesting that the trend has a higher probability of reversing. Likewise, we would look for the opposite signals in a downtrend, where the price action would be showing lower lows and lower highs, but the indicator would instead be giving us signs of strength, suggesting the possibility of waning momentum and an upcoming move to the upside. To summarize, price and the indicator are doing the opposite thing, or diverging.

So, with this is mind, we can conclude that:

Convergence = Higher Momentum = Possible Trend Continuation
Divergence = Lower Momentum = Possible Trend Reversal

As I stated before, the traditional measure of convergence and divergence has been the MACD indicator, but if we understand the concept itself, we can substitute this tool for another and get the same results. Which one is right? The simple answer is whatever you prefer. It is the use of the indicator and the analysis itself that will ultimately define the results for the individual trader. For this example, I will use the Commodity Channel Index (CCI) for the study. The definition of the CCI is that it is a measure of market or price strength. It gives us signs of overbought and oversold conditions in price action. Developed by Donald Lambert, the CCI calculates the distance between a price and its average over a set period of time. The default settings are usually 14 or 20 periods (depending on your charting platform and personal choice), and obviously, this can be adjusted like any other technical indicator. I like to interpret the CCI as a speedometer of the market, making it an ideal measure of momentum in prices. And perfect for my convergence and divergence analysis.

With this in mind, let's now put these ideas into practice by combining the CCI with some convergence/divergence analysis on a recent example of price activity on the USD/CAD currency pair.

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Figure 1 - Click to Enlarge

On this four-hour chart of USD/CAD, I have marked off three key pivots marked as A, B, and C, and applied the CCI indicator with a setting of 20 periods. In these examples, I would like to state that we are not focusing our attention on the overbought and oversold buy and sell signals the CCI is generating, but rather using the CCI to measure momentum in the price moves. Notice how between point A and point B, we saw a downward trend in price, with lower lows and lower highs? At the same time this was happening, we also saw a weakness in the CCI, with it too making lower lows and lower highs as marked by the blue circles. Since both indicator and price were doing the same thing, we can assume there is still momentum in the downtrend, or convergence. Upon reaching point B on the chart, we then began to see buying pressure enter the market and the USD/CAD then reversed into an uptrend.

What were the signals of this upcoming change in direction? Well, we can see that the CCI began to put in higher highs and higher lows between March 17 and 19, suggesting that downside momentum was drying up, or creating divergence. For the next few days, the currency pair enjoyed a decent upside move with higher highs and higher lows, while the CCI exhibited similar traits as well, presenting us with convergence once again, or momentum. However, it should also be noted that between the March 25 and 29, on the approach to pivot C, while the price was still moving up, our CCI was making lower lows and lower highs, as marked again by the blue circles on the chart. Strength in price and weakness in the indicator suggests dying momentum in the trend, or divergence. Could this be a sign that the upward trend is coming to an end? Let's see how things turned out:


Figure 2 - Click to Enlarge

Momentum did indeed subside, and upon reaching the 1.0300 level, the USD/CAD fell to just below parity with the US dollar putting in a low of 0.9975. This move was also complemented by convergence with the CCI also giving signs of weakness, as highlighted on the above example. Once again, however, as the pair was approaching the 1.000 level, the CCI showed us subtle signs of strength by putting in a higher low and diverging away from price before the bounce we can see happened at 1.000, to at the time of writing this article, 1.0073.

I am sure you will agree that a simple and logical understanding of how convergence and divergence shows itself on a price chart can be a powerful weapon in the hands of the disciplined trader, but it must be stated that these techniques are nowhere near good enough to base trading decisions upon alone. Any technical indicator should only be used as an analytical tool, not a decision maker for a taking a trade. As you can see from the above example, even without using any kind of convergence/divergence analysis, there was a low-risk, high-probability trading opportunity to short USD/CAD at 1.0300 anyway, simply because price rallied into an objective area of supply, or resistance, within the context of a bigger downward trend. Price alone is the only thing a trader will ever need as an analysis tool, but it can do you no harm at all to add something a little extra from time to time to increase the overall probability for success. I hope this helped.

By Sam Evans, instructor, Online Trading Academy

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