This type of forex divergence is the most important one. It looks at two or three correlated trading assets to identify institutional accumulation or distribution.
It is known as SMT (Smart Money Technique) Divergence or divergence in price. You can think of this as a signal from institutions that they are stepping in, and the price will see an explosive move soon.
Divergence in price or SMT Divergence doesn’t rely on conventional lagging indicators. Instead, traders study a correlated asset and look for mismatches there. A typical instrument here is the dollar index (USDX), which is used to replace the indicator.
USDX (or ‘Dixie’) is an index tracking the dollar’s value relative to the currencies of six of its prominent trading partners: EUR, CHF, JPY, CAD, GBP, NZD, & AUD.
When the index is up, any pairs where USD is the quote currency (e.g., EUR/USD) tend to go down – inversely correlated.
Conversely, if USDX is bearish, markets where USD is the base currency (e.g., USD/CAD) often move upwards – positively correlated.
Studying these direct relationships while incorporating this type of forex divergence is highly advantageous in forecasting movements. It can be used to identify potential reversals in trends or trend continuations after retracements.
The dollar index is just one example of a correlated asset. You can find interesting correlations in other indexes as well. For instance, you can study the correlation among the three major indexes: S&P500, NASDAQ, and Dow Jones.
However, for the sake of this study, we will stick to what is widely popular and easy to understand, which is looking at the correlation of DXY vs EURUSD.
With SMT forex divergence, you simply match the highs and lows of a particular pair (e.g. EURUSD) against an index (e.g. DXY) or other instruments.
Generally, in normal market conditions, when DXY makes a higher high, EURUSD would make a lower low.
However, when these assets do not respect their inherent correlation, we can assume ‘smart money manipulation.’
When looking at bullish or bearish SMT forex divergence, it will depend on which trading asset we are looking at. For example, if we look at DXY vs EURUSD, as they are negatively correlated assets, a bullish divergence occurs on DXY or a bearish divergence on EURUSD.
So, let’s dive into what makes a bullish or bearish SMT forex divergence on DXY vs EURUSD.
