Boris and Kathy's FX Blog www.bktraderfx.com

Fundamental Divergence

Anyone who has traded for more than a week is familiar with the concept of divergence. In technical analysis it basically boils down to this - price and momentum begin to register different readings. For example Price may make new highs but RSI does not. Almost all double tops and double bottoms are examples of divergence.

Does it work all the time? Absolutely not. Momentum may slacken - but instead of a turn in price it may simply signal a pause. That's why trading divergence with stops is essential for long term success.

Nevertheless divergence is the underlying foundation of most technical setups. The primary reason for its popularity is the asymmetrical nature of risk in the trade. If you can catch the turn in the pair the reward can be 2 or 3 times the risk - so only a 50% rate of accuracy gives you a tremendous edge.

As nice as technical divergence is - we like to trade fundamental divergence. What is that exactly? Fundamental divergence occurs in the currency market when economic news is unambiguously bad but price action responds positively. This setup is most effective when price is already in overbought territory and bad news makes it go even higher and works worst when price is oversold because the impact of bad news on oversold conditions is far smaller then on overbought conditions.

Basically - if price action doesn't make logical sense its usually wrong. Yesterday was a perfect example of this rule in action. US data printed miserably with ISM Services dropping below expectations and ADP forecasting a very weak NFP - yet the dollar rallied in the immediate aftermath of the news. This is akin to a poker bluff. The banks and the hedgies probably had a lot of dollar long inventory and they suckered dumb money to cover their greenback shorts while they themselves most likely bailed out of their positions as the buck rallied. Three hours later the euro and swissie gained 40 points and all was right with the world. Fundamental divergence in action.


This setup is by no means fool proof. Sometimes price can and will trade against the news decimating your equity if you don't nip it in the bud. That why we always use swing highs/lows as my technical reference points and put our stops there.

Hey - sometimes we may trade fundamentally but we always manage our money technically :).

posted by BKTrader  # 10/05/2006 06:58:00 AM