A Wealth of Knowledge
MACD is arguably one of the mostly used indicators by traders worldwide. However, it is famous for its simple yet powerful trade set-up called "MACD divergence ". This Page aims to explain how to spot and trade MACD divergence. For more information about the indicator itself click here
MACD divergence refers to a phenomenon where the MACD indicator deviates from the price movement. According to Cambridge online dictionary "to diverge is to follow a different direction, or to be or become different" (n.d.). So using the above mentioned definition, one should be able to decipher what to look for in order to spot MACD divergence. One should look for the time when the MACD histograms stray from the current price movement. Say for instance the price made a higher high on the chart and when one looks at the MACD indicator they find that instead of the MACD doing the same thing, it has rather deviated from the price. It made a lower high. This then becomes a indication to traders that the bullish momentum is fading away. It tells an informed trader that a reversal or a retracement is yet to occur.
So, how does one trade a MACD divergence you ask? well, the first question should be "how does one spot a divergence?". Given the above definition, one shouldn't find it hard to spot a MACD divergence. However, please kindly view the picture below as it provides an example of what it looks like, and will give one something to work from. By looking at the picture below, one can see that the price made a lower low, however when one looks at the MACD they will notice that the MACD did not agree with the price. It is said that the MACD had made a divergence should such happen.
One should be on the constant lookout for a point where the MACD deviates from current price movement. As depicted on the picture above, price made a lower low, but the histograms made a higher low. Which then is a signal that price is yet to change, or reverse or make a correction or retracement. However, it is not always easy to spot the difference between MACD histograms. Being that one has to wait for the current histogram to close shorter than the previous histogram.
How to trade MACD divergence
So upon one spotting a divergence, the question becomes, how does one trade it? One is to wait for the MACD to make a shorter histogram from its previous histograms. This means that prices are changing, thus a shorter histogram is an indication. So upon spotting a MACD divergence, is to wait for a shorter histogram relative wise. In comparison to the previous histograms, the histogram one is to take a trade on has to be a shorter histogram as already explained. So how does one see If a histogram is shorter than the previous histograms? An easiest way would be to compare the histogram values by simply moving the cursor/ arrow or mouse over the MACD histograms. When one does this, a small pop up box will appear with the following information: MACD, Time, Value, Signal. Next to this information there will be actual specifications of that histogram. For instance, next to where it says "MACD" in that pop up box it will display the settings used to calculate the histograms which is basically (12, 26, 9) of which is useless when one wants to know the difference between histograms. Then below "MACD" there is "Time" which basically the time that histogram formed and closed, which is too irrelevant. Then beneath that information there is "Value" which is the actual value of that histogram.
This is what we use to compare the difference between the histograms, the values. One has to ignore all the other information displayed in that pop box but only focus on the "Value" which will give one the value of that histogram. Then one is to compare the values of both the previous histograms value to the current value, being that if the current value (after it has closed) has a smaller number compared to the previous one then that is a signal that that histogram is shorter than the previous one. For instance say the previous histogram's value is 1.000 and the following histogram's value is 0.900. This means that the histogram with the value of 0.900 is shorter than that of the value of 1.000. This would then trigger a MACD divergence trade, because not only is there a MACD divergence but as well the MACD has made a shorter histogram.
MACD divergence itself is a consequential set up, however it is always better to compliment it with something else. Say for instance, the price has made a double bottom formation which in itself is a reversal formation, two lows at the same price level. Furthermore one also spots a MACD divergence. This becomes a high probability trade, as such that there are two reasons which compliment each other. Another example would be to look for candlestick information to compliment the divergence one has spotted. A hammer or a shooting star will make it a more probable set up. One can also use another indicator to confirm, say stochastics overbought and oversold signals. For instance the MACD divergence example posted above on EUR/AUD there was obviously a divergence between price and MACD histograms but had one loaded their stochastics they would have realized that prices are oversold.
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