Are You Trading MACD Divergence Correctly?

Are You Trading MACD Divergence Correctly?

One of the most powerful technical indicators that you can use in any market is the MACD oscillator, invented by Gerald Appel in 1979.  The MACD, which is short for moving average convergence divergence, is one of the most popular lagging indicators among traders as well.

Many traders use this indicator to trade divergence between the indicator and price, which can be a powerful trading technique if done correctly.  Are you trading MACD divergence correctly?  In this article, I’m going to show you how to trade MACD divergence like the pros.

Are You Trading MACD Divergence Correctly?

For starters, you should determine whether or not you are using the best MACD indicator for the job.  For instance, the default MACD indicator in MetaTrader 4 does not use the original MACD formula and is completely useless when it comes to trading traditional histogram divergence.

I’ve also seen MACD indicators, in other trading platforms, that only display the histogram, leaving out the MACD and signal lines.  In order to trade MACD divergence the way I’m going to teach you, you need to use a true, traditional MACD oscillator.

True MACD indicator

The image above is an example of a traditional MACD oscillator.  You can see the histogram (bar graph) in gray, the MACD line in blue, and the signal line in red.  Of course, the colors can vary between platforms and indicators, or due to user settings.

The MACD line is the fast line.  The signal line is the slow line (average of the MACD line).  The histogram shows divergence between the MACD line and signal line.  Click here to learn how these are calculated.

What is MACD Divergence?

The typical definition of MACD divergence is when price and the MACD indicator are going in separate directions.  As a trading method, at least in our case, we’re not talking about the divergence between the MACD line and the signal line.

MACD divergence is, for example, when price is making lower lows while the histogram or MACD line is making higher lows or double bottoms.  The idea is that the slowing momentum displayed by the indicator could be an early sign of a reversal.

In the example I mentioned, we would have bullish divergence.  We would have bearish divergence if price were making higher highs while the histogram or MACD line was making lower highs or double tops.  Similarly, price could make a double top while the histogram or MACD line made lower highs.

How to Trade MACD Divergence

In the image above, I marked the bullish divergence in green and the bearish divergence in red.  Notice that I marked divergence when price was either down trending or up trending.  I completely ignored the range bound period.

There are a couple of shortcomings to trading MACD divergence, and trading from a ranging market is one of them.  During a ranging market, the MACD and signal line will cross the zero line frequently.  You should avoid trading divergence, and possibly trading altogether, during these periods.

Note:  It’s also important to trade MACD divergence from distinguishable higher highs or lower lows in price.  For instance, the bearish divergence (red) in the image above barely qualifies, because there were such small retracements in price during that uptrend.

Keys to Trading MACD Divergence Correctly

When traders first realize how powerful trading MACD divergence can be, they often make the mistake of trying to trade the MACD on its own.  I don’t recommend this because the MACD can give many false positives on its own.

Instead, I recommend using MACD divergence strategies with other trading strategies – preferably ones that use leading indicators, like price action or support and resistance.  The right combination of lagging and leading indicators can provide you with a real edge in the market.

In the image below, I marked the bullish divergence (green), the bearish divergence (red), and an example of bad divergence (gray).  I also marked some entry signals.  For the purpose of this article, we will be using price action signals in conjunction with the different forms of MACD divergence.

Trading MACD Divergence Correctly

Click the image above to see a larger version.

Starting from the left, you can see some traditional MACD histogram divergence.  The histogram is making higher lows or double bottoms, while price is making lower lows.  If we were using price action as our confirming entry signal, we would have skipped the first two examples of bullish divergence, because there were no bullish candlestick signals to confirm our entry.

The next two examples show both histogram and MACD line divergence.  They also both developed bullish engulfing signals which could be used to confirm entry at each of those divergence points (click the image for a better view).

Note:  Oddly enough, according to the way I trade candlestick patterns, I would have made a full take profit (2:1) after the first bullish engulfing pattern.  I would have been stopped out at break even, if I had taken the second bullish engulfing pattern.  At first glance, you would think it should be the other way around.

Next, we have an example of bearish divergence.  A strong candlestick signal, the bearish engulfing pattern, developed at this point as well, confirming its significance.  During this period, the divergence occurred between price and the histogram.

Divergence also occurred between price and the MACD line.  You’ll notice that the MACD line only made a small kink (or micro divergence).  Micro divergence can occur when price is making smaller retracements, or during periods of high volatility.  Either way, micro divergence can be a very significant signal in the right situation.

After that, I marked a bad example of divergence.  The reason this doesn’t qualify as a good example of divergence is because the retracement that made the first low was so small that it’s barely noticeable. Remember what I said about distinguishable higher highs or lower lows in price being important?

Price action through this area is too smooth.  There was not enough up and down movement in price to establish any distinguishable lows.  Compare this period to the downtrend on the left of the image.  There you can see very distinguishable lower lows in price.  The lows on the histogram were also very distinguishable, which is helpful but not critical.

Next, we have another example of bullish histogram divergence.  This bullish divergence also coincided with a possible bullish candlestick signal, a bullish engulfing pattern.  However, the real bodies of the candlesticks are relatively small compared to the other candles in the area.  For that reason, I would have skipped this trade, although it would have worked out.

Finally, we have another example of bullish divergence that occurred between price and both the histogram and MACD line.  In this case, there was no candlestick signal to confirm a trade, so we would have stayed out of the market.

Hopefully, you can see from the examples that I’ve given that learning how to trade divergence between the MACD and price can be a very powerful tool in your arsenal.  Trading MACD divergence in combination with almost any other type of trading strategy can increase that strategy’s profitability exponentially.

Final Thoughts:

Trading MACD divergence, if done correctly, can provide you with a real edge in the market.  It can be a powerful early indicator of trend reversals when combined with another trading system – preferably a system based on leading indicators.

MACD divergence isn’t foolproof.  This technique does not work well in range bound markets, and on its own MACD divergence will often give you many false positives.  This is especially true when the market is trending strongly in one direction for an extended period of time.

It is important to only trade divergence signals that occur during periods of distinguishable higher highs or lower lows in price.  Strong, parabolic moves in price, in one direction or another, with little to no retracement, do not make good divergence signals.

Are you trading MACD divergence correctly?  Hopefully, this article shed some light on any mistakes you might be making with this popular trading technique.  Like anything else in trading, you can’t expect to be an expert divergence trader overnight.  Be sure to do plenty of backtesting and demo trading before trying any new trading strategy in your live account.

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  1. Icekopi July 13, 2016
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