In binary options trading, divergences are very popular as they have a clear advantage – they are clearly visible which makes buying binary options simple. They are a vital tool for both intermediate and experienced traders in binary options trading as the basic theory for all divergences is the same, regardless of how it was formed.
The definition of a divergence is “moving or drawing apart”, and it can be described by 2 lines which extend from a common centre. This occurs when an asset’s price and a specific indicator move in completely opposite directions. A divergence signifies market weakness and is an indication of potential reversal. As momentum declines, eventually it leads to potential correction and an exhausted market.
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How to Trade Divergences in Binary Options Trading
It is important for traders to remember that divergences are a tool and not a signal. While divergences are a good measure of the market, investors are not advised to use them unless they are combined with other signal providing indicators. When divergences are applied properly to technical analysis, they can predict a reversal in the market with considerable success, however by themselves, they cannot give a clear signal of the exact time when the reversal will take place. A market that is strongly trending could be in the process of winding down for an extended period of many months or even several years. However, divergences should not be discounted as they are a powerful investment tool that can only gain in strength when it is used in conjunction with other tools.
To have a divergence, traders need to compare an asset’s price with an indicator such as an oscillator which will either confirm or not the movements of the asset’s price. For the divergence to be valid, both the oscillator and the asset price’s moves should be compared and should there be a difference between them, they are said to be moving divergently. As a rule, if the oscillator is taking a rising path, however the asset’s price is on a falling one, the divergence is said to be bullish and the trader should buy call options. Conversely, if the asset’s price is on a rising path but the oscillator is on a falling one, the divergence is said to be bearish, and the investor should instead purchase put options.
Expiry Periods in Trading Divergences
The expiry date is determined by the time frame of the divergence and by the trader’s own strategy. Generally, it is wise to stick with the oscillator when looking at divergences as the oscillator is taking more candles into account than the price. Divergences can be tricky however, as the time frame is very important. If it is forming across a larger time frame, such as a daily chart, it can be hard to pick the correct expiry date as there may be no expiration of the correct size. Therefore, the most advantageous way to trade divergences is to keep to low time frames, with the hourly chart being the best time frame to consider as spotting a divergence on this chart type allows you to trade any expiration date that you prefer.
Analysis of the time frame is a key area in which divergences prove helpful in predicting trading entries. For example, time frame divergences may occur when the price moves higher over the long term, but lower in the short term, or when indicators over a long time frame point up when indicators point down over the short term meaning that it would be a good time to take a long term position.
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- Bates, D. S. (1997). The skewness premium: Option pricing under asymmetric processes. Advances in Futures and Options Research, 9, 51-82.
- Tompkins, Robert G. “Static versus dynamic hedging of exotic options: an evaluation of hedge performance via simulation.” The Journal of Risk Finance 3, no. 4 (2002): 6-34.