Oscillators such as the relative strength index (RSI) and the momentum indicator, in a sense, measure the emotional pulse of the forex trading market. As hope and fear wax and wane by turns in the marketplace, the oscillators respond by indicating the level and strength of each emotion and the speed of its passing, giving the savvy trader a feel for where such emotions may take the currency pair’s price.

At no other time is the oscillator more valuable than when market sentiment and price do not agree. This event, known as divergence, signals that traders’ emotions toward a given currency pair are changing. Because it is often the price that corrects to match the sentiment, divergence is generally considered to herald a change in trend.

There are several different sorts of divergence. The two major categories are bearish and bullish.

Bearish divergence occurs when the price is making new highs but market sentiment, lagging behind, only reaches a lower high. This occurs because price action carries a certain amount of inertia with it, but forex traders are no longer quite so keen on going long the pair at such a high price and therefore buying momentum is waning as the bears win the field. If confirmed by other indicators, this is a sell signal for closing out long positions and an entry signal for going short.

Bullish divergence, of course, is the opposite, with the price reaching lower lows but the RSI or momentum indicator not following suit and only reaching higher lows as selling pressure wanes in favour of the market bulls. Again with confirmation, this is an exit signal for existing short positions and an entry signal for long ones.

Take note of this chart:

This is the one-hour current chart of the AUD/NZD, with recent support and resistance levels marked in horizontal green lines, and five technical indicators. There are two purple five-period moving averages, calculated on the open and close, forming a channel bracketing the heikin ashi candles. Crossing the chart is a 200-period exponential moving average in grey to illustrate the long-term trend. In the centre window is a 14-period RSI in yellow; below, a 14-period momentum indicator in blue. The slanting green lines in all three windows illustrate bearish divergence, with the price forming higher highs but both oscillators below only forming lower highs.

Is there perhaps some confirmation for this bearish signal? Note that the RSI, for the most part, has remained in the upper part of its range for some time now, although that means less in forex trading than in stocks. Also note that the currency pair is at an historic high level, where market exuberance could take over and push it even higher, while fundamentals do not support any prolonged downturn in trend.

Finally, the currency pair has demonstrated such divergence in the past. Note the slanting green lines on the same chart from the middle of June (the 200-MA has been removed to clarify the view):

The currency pair turned down only briefly for profit-taking on 19 June 2008 before resuming its uptrend, giving the suspicion the same pattern could be repeating.