In the world of supply and demand trading, confirming a zone’s potential for causing a reversal often involves looking for confluence or assessing the zone’s strength.
Both methods work fine, but there’s another tool to add to your arsenal:
Divergence.
Let’s explore how to use divergence to confirm supply and demand zones, enhancing their potential for causing reversals.
Intrigued?
Let’s dive in.
What Is Divergence, And How Does It Work?
Your probably wondering:
What is divergence and how does it function?
The concept of divergence occurs when two sets of data show conflicting signals. In forex, divergence manifests when price movements contradict a technical analysis (TA) indicator.
For example:
If price is falling but the Relative Strength Index (RSI) is rising, that’s divergence.
There’s a mismatch between what the indicator shows and the current price action, which suggests there’s something big happening behind the scences. In this case, bullish momentum was building, indicating price may soon reverse, which it of course then did.
The most common way to identify divergence involves the MACD (Moving Average Convergence Divergence) indicator, created by J. Wells Wilder.
Primarily used to measure trend strength, the MACD can also reveal divergence.
This occurs when price hits a new high or low, but the MACD lines show the opposite.
For instance:
- Price forms a new high and the MACD forms a lower high = bearish divergence.
- Price forms a new low and the MACD forms a higher low = bullish divergence.
In both scenarios, the MACD’s divergence suggests a potential reversal.
Divergence is a potent signal for reversals on its own.
However, it truly shines when used as a secondary confirmation tool alongside other TA concepts—in this case, supply and demand zones.
Supply and demand zones are high probability market reversal points, but they aren’t foolproof. Zones can fail, often without warning. But seeing divergence when price returns to a zone can be a strong indicator the zone has a high probability of causing a reversal.
Consider the supply zone below…
Price just moved into this zone, making a new higher high in the process.
But what’s the MACD up to?
Bearish divergence!
Price made a new high, MACD creates a lower high. That’s a clear sign the market price and the average price are off-sync, hinting at a high chance for a reversal.
And would you look at that!
As soon as the high forms, price reverses, and a new downswing begins.
See the potential in this now?
How To Confirm Zones Using Divergence: 3 Step Guide
Checking supply and demand zones using divergence is a breeze, requiring only a few quick steps.
- Locate your zone.
- Add the MACD indicator.
- Enter a trade when the right signal appears.
Let’s go through a quick example, so you can see how this works.
Step #1: Locate Your Supply Or Demand Zone
First, identify your supply or demand zone.
Any zone on any timeframe works, but ensure it meets the characteristics of a strong zone.
Remember, divergence confirms, but doesn’t strengthen a zone.
For that, you must look at other factors.
For this example, let’s use a supply zone.
Step #2: Use To MACD To Spot Divergence
Next, apply the MACD indicator to spot divergence.
Find MACD under the ‘Indicators’ tab on Tradingview, or via the ‘Insert’ tab on MT4/5.
The MACD should appear underneath your chart.
If you use MT4/5, hover over the “Insert” tab at the top and move your cursor over indicators. Now find the Oscillators tab and hit MACD to add the indicator.
Now for the important part:
Divergence occurs when the MACD and price show opposing highs/lows.
- Bullish Divergence = price makes a new high; MACD forms a lower higher.
- Bearish Divergence = price makes a new low;MACD forms a higher low.
How does this translate to supply and demand zones?
Simple:
- When price is rising into SUPPLY – look for BEARISH divergence.
- When price is falling into DEMAND – look for BULLISH divergence.
Let’s switch back to our example and check for divergence. We’re looking for a lower low on the MACD when the price is forms a new higher high.
Here’s what happens…
Well, would you look at that!
Just after the new higher high formed, the MACD printed a lower high.
Hello, divergence!
We’ve got the MACD and price showing conflicting signals, hinting a reversal might be in the works. The MACD (i.e., the average price) and the actual price are diverging, suggesting bearish momentum is growing behind the scenes and ready for a reversal.
And where’s the prime spot for the reversal to begin?
You got it – the supply zone!
Now we just sit tight and keep our eyes peeled for an entry signal…
Step #3: Enter A Trade (If Everything Checks Out)
Entering a supply or demand zone trade with MACD divergence? It’s no different from entering any regular S & D trade:
You’ve must wait for a price action signal within the zone.
We’re talking about a pin bar with a large standout wick or an engulfing pattern with a beefy second candle (yeah, that’s the engulf). These patterns indicate the banks are entering trades at the zone, which significantly raises the probability price will reverse.
In our case, a bearish engulfing forms…
The engulf appears right after price moves into zone, so now we have confirmation the banks are selling and can enter our sell trade.
We jump into the trade, placing our stop right above the upper edge.
And then, after the pattern forms…
Price nosedives, and we find ourselves riding a sweet short trade.
Easy, isn’t it?
That’s the beauty of using divergence – it layers on a heap of confirmation to your zones. Sure, we knew this zone was powerful already, but the divergence only provided more evidence, which gave us more confidence to take the trade and enter short.
The Bottom Line
Craving more certainty from your S & D trades?
Keep an eye out for divergence.
Zone strength and confluence are all well and good for confirming supply and demand zones, but divergence adds another layer of confirmation. It provides a strong hint momentum is changing behind the scenes, increasing the chance the zone will trigger a reversal.