SMT divergence refers to the difference in the price action structure of two positively or negatively correlated financial assets. This method helps us to find the trend reversals in the market.
In price action trading, we mostly use this method to find trend reversals by identifying imbalances between two financial assets. For example, it’s a fact that two correlated pairs should move mostly in the same direction. However, if they are moving in opposite directions, then there exists an imbalance. From this imbalance, we can determine that in the future, prices will balance themselves, and this makes it easier for us to forecast price movements.
In this post, I will explain SMT Divergences in detail, so don’t skip any step and read the full post.
What is SMT divergence in Trading?
SMT divergence stands for smart money trading divergence. We use price action and correlation to find the divergence between two financial assets and then forecast price reversals accordingly.
It is the same as normal divergence, but here we will compare only correlated financial assets to find divergence. We will not use any mathematical indicators to find the Divergences.
SMT divergence is categorized into two types based on the forecast and correlation type:
- Bullish SMT Divergence
- Bearish SMT Divergence
Positive correlation SMT Divergences
If one financial asset is making a higher high and the other is making a lower high, then there’s bearish SMT divergence.
While if one financial asset is making a lower low and the other is making a higher low, then there is bullish SMT Divergence between them.
Remember that pairs must be positively correlated with each other to find such types of SMT divergences.
Also, analyze the images below for a better understanding of this concept.
I know it will be a bit confusing at the start, but after practicing this method, you will find these divergences by just looking at the charts.
Negative correlation SMT divergences
If one financial asset is making a higher high and the other is also making a higher high, then there’s a bearish divergence.
Remember that in negative correlation, both financial assets or currency pairs must move in opposite directions, but if they are moving in the same direction, then this means there’s a divergence between both financial assets.
On the other hand, if one financial asset is making a lower low, then the other will also be making a lower low, which means both are in bullish divergence.
Psychology behind the SMT divergences?
In trading, it’s a mathematical fact that if two currency pairs are correlated with each other, then they will always move in the same direction. However, if they start moving in opposite directions, then this gives us a clue that there’s a fakeout in the market or there’s an imbalance between both pairs. Sooner or later, the market will have to come to a balanced state (again in the same direction). So by using bullish and bearish divergences, we can forecast a reversal easily and accurately.
However, you should always keep in mind that you first need to find the correlation between two pairs, then find the type of bullish or bearish SMT divergence. Because the method to find bullish or bearish SMT divergence is different for both positively and negatively correlated financial assets or currency pairs.
How to trade the SMT divergences?
We cannot trade the SMT divergence alone without the confluence of any other signal. If we combine it with a trading strategy, then the probability of winning will increase.
We can also combine the confluence of a major key level along with a reversal candlestick pattern.
For example, if there’s a bearish divergence between two positively correlated financial assets, then it forecasts that the price will take a bearish trend reversal soon. But we cannot open a sell trade blindly at this point. So we will first zoom out the chart and look at the history to determine a strong key resistance level. Now we will have a close eye on the financial asset that is making a higher high. Once it makes a bearish candlestick pattern at a key resistance zone, then we will open a sell trade and place a stop loss above the high of the candlestick or above the high of the key resistance level. For take profit level, we can use the nearest fair value gap, etc.
This is how you can trade the SMT divergences. It’s a very helpful price action-based tool to identify reversals in the market.
The bottom line
I highly recommend you to trade the SMT divergence with the confluence of a trading strategy. If you have a trading strategy, then SMT divergence can give you many successful trade setups.
Also remember that financial assets must be highly correlated. If there is little or no correlation, then you should not check for SMT divergences between them.
I hope now you will be able to determine these divergences accurately on the chart. Also, don’t forget to backtest this method many times to master it.
If you have any questions related to SMT Trading, then don’t forget to comment below this post.