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Divergence Trading? Is this part of great systems trading?

A question arrived recently:

A fellow trader told me “the trend is your friend and you should trade in the direction of the trend, unless there is a major divergence. If there is a major divergence, the divergence is your BETTER friend and probability favors trades (in the next lower time frame, ala Elder’s triple screen) in the direction of the major divergence”. Do you agree with this statement? Is this something you have studied? An example of a major indicator divergence is defined as a MACD line and histogram divergence, when the macd hist rises/falls below 0 (see chart below).

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This is a great question as it offers us a chance to argue the bigger picture. There is an assortment of indicators one could use for entry and or exit. For example, some of the best traders use price breakouts. But fixating on a magical indicator solution misses the point unfortunately. What should you do instead? Answer these 5 questions:

  1. How does the system determine what market to buy or sell at any time?
  2. How does the system determine how much of a market to buy or sell at any time?
  3. How does the system determine when you buy or sell a market?
  4. How does the system determine when you get out of a losing position?
  5. How does the system determine when you get out of a winning position?

Answer these 5 questions first. If your divergence indicator idea is part of answering the 5 questions — go for it — after sufficient testing.

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