The MACD is very popular among traders, yetthere's more to using and understanding it than meets the eye.
The MACD uses moving-average lines to illustratechanges in price patterns.
MACD is a great indicator to confirm the setups, locate and follow the trends, no matter what trading system you trade.
Among all the signals or patterns that MACDmakes, a MACD divergence is my favorite and the most reliable leading signals I couldget.
A divergence in general occurs when the priceaction is seeing lower lows while in a downtrend, but the indicator is not reflecting that move.
Similarly, when the markets are trending higher, you notice divergence when the price action is seen scaling higher highs but somehow theindicator remains firm of the changes, and forms lower highs.
So, when the price of an asset, such as astock or currency pair, is moving in one direction and the MACD's indicator line is moving inthe other, that's divergence.
This type of signal is supposed to warn ofa price- direction reversal, but the signal can be misleading and inaccurate.
Another type of divergence is when a security'sprice reaches a new high (or a new low) level, but the MACD indicator doesn't.
Essentially what it conveys is the shift inthe market momentum.
After all, the markets are driven by momentumand the momentum is the force that oscillates between highs and lows and thereby bringingthe changes in the price action.
Traditionally, this would indicate that theprice's direction is losing momentum and is priming for a reversal.
But, by its own, this can also prove to bean unreliable trading signal.
While you don't need to understand the maththat underlies the calculation of the MACD, by understanding more about how the MACD indicatorworks, you'll be better positioned to avoid getting fooled by its false signals or lackof signals, such as when the price turns but the MACD doesn't provide any warning.
So, let’s discuss about the main issueswith MACD divergences.
First, MACD divergence after a sharp moveMonitoring the MACD indicator in relation to price action reveals a few problems whichcould affect traders who rely on the MACD divergence tool.
A divergence pattern between the two MACDlines will almost always occur right after a sharp price move, whether higher or lower.
Determining whether a price move is sharp, slow, large or small requires looking at the velocity and magnitude of the price movementsaround it.
Price momentum can't continue forever so assoon as the price begins to level off, the MACD trend lines will diverge (for example, go up, even if the price is still dropping).
After a strong price rally, the MACD divergenceis no longer useful.
By dropping, while the price continues tomove higher or move sideways, the MACD is showing momentum has slowed but it doesn'tindicate a reversal.
In this example, the EUR/USD is falling, yetthe MACD is rising.
Had a trader assumed that the rising MACDwas a positive sign, they may have exited their short trade, missing out on additionalprofit.
Or they may have taken a long trade, eventhough the price action showed a significant downtrend and no signs of a reversal (no higherswing highs or higher swing lows to indicate an end to the downtrend).
That doesn't mean divergence can't or won'tsignal the occasional reversal, but it must be taken with a grain of salt after a bigmove.
Since divergence occurs after almost everybig move, and most big moves aren't immediately reversed right after, if you assume that divergence, in this case, means a reversal is coming, you could get yourself into a lot of losingtrades.
Problems with divergence between MACD highs(or lows) Traders also compare prior highs on the MACDwith current highs or prior lows with current lows.
For example, if the price moves above a priorhigh, traders will watch for the MACD to also move above its prior high.
If it doesn't, that's a divergence or a traditionalwarning signal of a reversal.
This signal is also related to the problemdiscussed before.
A lower MACD high-price level shows the pricedidn't have the same velocity it had last time it moved higher (it may have moved less, or it may have moved slower), but that doesn't necessarily indicate a reversal.
As discussed above, a sharp price move willcause a large move in the MACD, larger than what is caused by slower price moves.
An asset's price can move higher or lower, slowly, for very long periods of time.
If this occurs after a steeper move (moredistance covered in less time), then the MACD will show divergence for much of the timethe price is slowly marching higher (relative to the prior sharp move).
If a trader assumes a lower MACD high meansthe price will reverse, a valuable opportunity may be missed to stay long and collect moreprofit from the slower increase higher.
Or worse, the trader may take a short positioninto a strong uptrend, with little evidence to support the trade except for an indicatorwhich isn't useful in this situation.
This example shows a downtrend.
The downtrend is caused by sharp downwardmoves, followed by slower downward moves.
This results in divergence when the next pricewave isn't as sharp, but in no way indicates a reversal on the MACD.
MACD divergence was present this whole time, yet the price dropped all day.
If monitoring divergence, an entire day ofprofits on the downside would have been missed.
Another problem with watching for this typeof divergence is that it often isn't present when an actual price reversal occurs.
Therefore, we have an indicator which providesmany false signals (divergence occurs, but price doesn't reverse), but also fails toprovide signals on many actual price reversals So, having these 2 MACD problems in mind, how you improve the accuracy rate of spotting divergences correctly using this indicator? I use 3 steps:First one.
It’s safe to say we must focus on the priceaction first, instead of divergence.
For a downtrend to reverse, the price mustmake a higher swing high and/or a higher swing low.
To reverse an uptrend, the price must makea lower swing high and/or a lower swing low.
Until these occur, a price reversal isn'tpresent.
Whether divergence is present or not isn'timportant.
Traders make money off price movements, notMACD movements.
The second step.
I look for double divergence patterns, meaningi want to see a divergence on both the histogram and on the signal and MACD line.
With the creation of a double divergence onthe charts, i prefer to draw a trend line on the charts and enter after a breakout.
This way, my stop loss is optimized belowor above the breakout and the entry points are clearly identified.
Keep in mind that a trend might continue overan extended period even after a double divergence.
So it goes without saying that your stopsshould be in place at all times to act as safety net against any potential misreadingor miscalculation of risks.
Another interesting factor, to notice in caseof a double divergence, is volumes will decrease when the second divergence is underway.
Thus, it is a point where the momentum andthe volume seem to arrive at common grounds to represent a specific price action phenomenon.
Here’s visa on a 15-min time frame.
We have a first divergence on the histogramhere.
The second divergence on the MACD line here.
The market was making higher highs and higherlows, so in order to trade the double MACD divergence, we needed the price to recorda lower low.
Which it did, and at the same time, we hadthe 3rd step completed, as the trend line marking the uptrend was broken to the downside.
With all 3 conditions met, a short after thebreakout was a high probability trade.
So we combined price action, with the MACD, to find a decent short trade.
The same pattern but on a downtrend.
The histogram divergence.
The MACD line divergence.
A higher swing high.
And the downslope trend line breakout.
Here are other examples of double MACD divergencetrades.
It goes without saying that the price actionneeds to be followed after you’re in a trade.
It does not mean that you have to be up andawake in front of the screen all day monitoring ever pip move but at the same time, you mustremember never to lose sight of the primary levels and how they need to be capitalizedin conjunction with the new trend in the market, which hopefully started after the MACD divergence.
And remember not to have irrational expectationfrom the market.
Set up realistic profit and loss targets andwork towards realizing the profit.
I like to use this double divergence strategyin my day trading activity, but it can also be used with as a swing trading tool.
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Until next time.