How To Identify and Trade SMT Divergences

SMT Divergences are a trading concept used by price action traders (also known as SMC or ICT traders). SMT Divergences are divergences of price between two correlated assets. Traders often use these divergences to identify mispricings or imbalances between related assets to exploit these opportunities for profit.

What are SMT Divergences

SMT Divergences are areas where the prices of two correlated assets don’t follow each other. These divergences can be an indication of a market reversal or shift in market sentiment. A divergence is formed when the price of an asset moves in one direction, but an indicator or oscillator (such as RSI or MACD) moves in the opposite direction. This same concept can be applied to two tickers instead of comparing the price of one ticker versus an indicator. If you look at two correlated assets and one stock continues in its trend while the other stock moves in the opposite direction, this is a divergence.

Market Correlations

There are three types of correlation that assets can have with each other: Positive Correlation, Negative Correlation, and No Correlation.

Positive Correlation

Positively correlated assets will move in the same direction. For example, if one stock goes up, the other stock will also go up. This typically occurs because both assets are influenced by similar economic factors, belong to the same industry, or are tied to the broader market's overall performance.

Examples of positively correlated assets:

JP Morgan Chase ($JPM) and Bank of America ($BAC)

Both are large financial institutions, and their stock prices tend to move in sync as they are affected by similar factors such as interest rate changes, financial regulations, and economic growth expectations.

ExxonMobil ($XOM) and Chevron ($CVX)

These two companies are both giants in the oil and energy sector, so they often move in the same direction due to changes in oil prices, geopolitical events, or energy market trends.

Negative Correlation

Negatively correlated assets will move in the opposite direction. For example, if one stock goes up, the other stock will go down. This relationship often exists between assets that respond differently to economic or market conditions, such as stocks and bonds, or between assets that represent competing industries.

Examples of negatively correlated assets:

Gold ($XAUUSD) and U.S. Dollar ($DXY)

When the U.S. dollar strengthens, gold prices tend to decrease as gold becomes more expensive for international investors, and vice versa.

Oil ($CL) and American Airlines ETF ($JETS)

Oil prices and airline stocks often exhibit a negative correlation. When oil prices rise, airlines face higher fuel costs, which can negatively affect their stock prices, while falling oil prices tend to benefit airlines.

No Correlation

Assets with no correlation will move independently of each other. For example, if one stock goes up, the other stock may go up, down, or remain unchanged. This relationship often exists between assets that are influenced by completely different factors.

How to Identify an SMT Divergence

To identify an SMT Divergence you must first look at two positively correlated assets. For the sake of this guide, we will use the S&P500 ($ES) futures and Dow Jones futures ($YM). Bullish SMT Divergences occur at lows, while bearish SMT Divergences occur at highs.

Bullish SMT Divergence

In this example, $ES forms a low (L), then a high (H), followed by a lower low (LL), and then a higher high (HH). Meanwhile, $YM forms a low, then a high, followed by a higher low (HL), and then a higher high.

Since $YM did not also form a lower low like $ES did, there is a bullish SMT Divergence between these two assets. You can draw the bullish SMT Divergence from the low to the lower low on $ES and from the low to the higher low on $YM.

Bearish SMT Divergence

In this example, $ES formed a high, then a low, followed by a higher high, and then a lower low. Meanwhile, $YM formed a high, then a low, followed by a lower high (LH), and then a lower low.

Since $YM did not also form a higher high like $ES did, there is a bearish SMT Divergence between these two assets. You can draw the bearish SMT Divergence from the high to the higher high on $ES and from the high to the lower high on $YM.

How to Trade SMT Divergences

SMT Divergences should be used as a form of confluence in trading, rather than a buy/sell indication. You should pair this concept with other indicators or trading concepts to find higher probability setups.

Long Trade

In this long trade example, a bullish SMT Divergence is formed on $YM, indicating a potential market reversal. However, SMT Divergences should only be used as a piece of confluence in trading, so we will wait for price to come to a key level before executing a trade. Once price jumps up, a bullish Fair Value Gap (FVG) is formed. When price retraces to the FVG, take a long entry, setting a stop loss below the zone and taking a 1:3 risk-to-reward trade.

Short Trade

In this short trade example, a bearish SMT Divergence is formed on $ES, indicating a potential market reversal. However, SMT Divergences should only be used as a piece of confluence in trading, so we will wait for price to come to a key level before executing a trade. We can see that there was a bearish Order Block (OB) formed near the same spot as the SMT Divergence. Once price retraces to the order block, take a short entry, setting your stop loss above the zone and taking a 1:3 risk-to-reward trade.