Trading Setups – The 1 2 3 Divergence

Today we've asked Tony Edwards to share his favorite trade entry setups with our readers. Tony Edwards has been an active independent trader for nearly 20 years. He trades an extremely wide range of instruments with a special focus on YM, ES, 6E, CL and GC. He offers traders daily, unique support and resistance levels ("TraderSmarts Numbers") as well as Live Trade Alerts via www.tradersmarts.net.

How do you determine when to enter a trade? For system traders entry is not arbitrary. If the specified parameters are present the system executes. For discretionary traders we choose every single entry that we take. It is up to us to physically pull the trigger. Over time all discretionary traders develop a few “go to” setups. These are the setups that have proven time and time again to be effective and profitable.

One of my favorite trade entry setups is what I call the 1 2 3 Divergence.

Divergence is simply when price and the indicator of choice are diverging from each other. There are both lagging and leading indicators but, in general, the indicator will go in the direction of price as most indicators are a division of price. If price is moving down the indicator will be moving down. Price leads the indicator. So if price makes a low you would expect the indicator to also make a low. We have positive divergence when price makes a new low and the indicator does not also make a new low. The indicator is positively diverging from price.

Negative divergence works in the same way. If price makes a new high yet the indicator fails to also make a new high, we have negative divergence.

Divergence can be used to gauge the strength of a move and help us determine when a move may be coming to an end. If price keeps making new highs yet the indicator does not keep making new highs, then eventually something has to give. Eitherprice, which leads the indicator, keeps going up in spite of the indicator until the indicator eventually rolls over and then goes on to make new highs, in effect catching up to price. Or price will give way to the indicator and roll over heading back down in the direction of the indicator.

Even though price leads the indicator, in this instance and in this select and allotted time window, the indicator is going to enforce its will on price. It is not really leading price because we know that price leads but that is an easy way to think about it. It is telling us that price has gone too far and too fast and could potentially be ready to experience some type of minor or major correction or possibly even a major “CIT” change in trend, depending on the timeframe we are analyzing. It is under these conditions that the 1 2 3 Divergence setup develops and we as traders are able to take advantage of it.

The 1 2 3 Divergence is simply when price makes 3 higher highs and the indicator makes 3 lower highs or when price makes 3 lower lows and the indicator makes 3 higher lows. We can look to go short when price is cresting at the top of its third higher high and look to go long when price is cresting at the bottom of its third lower low. This entry is especially powerful when price is lined up with a key TraderSmarts Number or some other factor is present on the third higher high or third lower low. You can look for the 1 2 3 Divergence on any timeframe from a 1 minute chart all the way up to a monthly chart.

Following are three examples of the 1 2 3 Divergence in action:

Today we talked about the 1 2 3 Divergence. It is a setup that you can incorporate into your trading arsenal today. Hope it helps!

Trade smart and trade well,
Tony Edwards

Tony is giving away a completely FREE trial to Traders Blog Readers. Click here to get started today!