Just a note on the popular topic of divergence. Technical traders often talk about price-oscillator divergence. For those that are unfamiliar with this concept, classic divergence simply means one of two things – that price has made a higher high while some oscillator has made a lower high (bearish divergence), or that price has made a lower low while some oscillator has made a higher low (bullish divergence). Bearish divergence, like its name suggests, is a sign that upside momentum may be failing and that there may be an impending downturn. Bullish divergence, on the other hand, is a sign that downside momentum may be failing and that there may be an impending upturn.

In the case of the current GBP/USD hourly chart as shown on the chart, a bearish divergence has indeed occurred within the last several days (represented by the diverging black lines highlighted in yellow), that was followed closely by a subsequent price drop. In this case, the divergence indication did in fact work – and it worked beautifully.

But it should be forewarned that divergence should not be taken as a complete trading strategy. Divergence signals taken alone, without confirming factors, can be a dangerous game. The best use of a divergence signal is to consider it a red flag. Once this red flag is raised, the astute trader will look for other factors to confirm an impending reversal. These other factors might include a reversal pattern or a key support/resistance level. In any event, it cannot be emphasized enough that divergences need confirmation.

- James

James Chen is the Chief Technical Analyst at FX Solutions, a leading Forex broker. He is also a registered Commodity Trading Advisor (CTA) and a Chartered Market Technician (CMT) Level 3 candidate. At FX Solutions, Mr. Chen writes daily currency analysis, conducts forex trading seminars, and has authored numerous articles on currency trading and technical analysis for major financial publications. His upcoming book, Essentials of Foreign Exchange Trading (John Wiley & Sons), will be released in early 2009.