MACD Divergence

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Trading the MACD divergence

Moving average convergence divergence (MACD), invented in 1979 by Gerald Appel, is one of the most popular technical indicators in trading. The MACD is appreciated by traders the world over for its simplicity and flexibility, as it can be used either as a trend or momentum indicator.

Trading divergence is a popular way to use the MACD histogram (which we explain below), but unfortunately, the divergence trade is not very accurate, as it fails more than it succeeds. To explore what may be a more logical method of trading the MACD divergence, we look at using the MACD histogram for both trade entry and trade exit signals (instead of only entry), and how currency traders are uniquely positioned to take advantage of such a strategy.

Key Takeaways

  • Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price.
  • Traders use the MACD to identify when bullish or bearish momentum is high in order to identify entry and exit points for trades.
  • MACD is used by technical traders in stocks, bonds, commodities, and FX markets.
  • Here we give an overview of how to use the MACD indicator.

MACD: An Overview

The concept behind the MACD is fairly straightforward. Essentially, it calculates the difference between an instrument’s 26-day and 12-day exponential moving averages (EMA). Of the two moving averages that make up the MACD, the 12-day EMA is obviously the faster one, while the 26-day is slower. In the calculation of their values, both moving averages use the closing prices of whatever period is measured. On the MACD chart, a nine-day EMA of the MACD itself is plotted as well, and it acts as a trigger for buy and sell decisions. The MACD generates a bullish signal when it moves above its own nine-day EMA, and it sends a sell sign when it moves below its nine-day EMA.

The MACD histogram is an elegant visual representation of the difference between the MACD and its nine-day EMA. The histogram is positive when the MACD is above its nine-day EMA and negative when the MACD is below its nine-day EMA. If prices are rising, the histogram grows larger as the speed of the price movement accelerates, and contracts as price movement decelerates. The same principle works in reverse as prices are falling.

Figure 1 is a good example of a MACD histogram in action:

Figure 1: MACD histogram. As price action (top part of the screen) accelerates to the downside, the MACD histogram (in the lower part of the screen) makes new lows.

Source: FXTrek Intellicharts

The MACD histogram is the main reason why so many traders rely on this indicator to measure momentum, because it responds to the speed of price movement. Indeed, most traders use the MACD indicator more frequently to gauge the strength of the price move than to determine the direction of a trend.

Trading Divergence

As we mentioned earlier, trading divergence is a classic way in which the MACD histogram is used. One of the most common setups is to find chart points at which price makes a new swing high or a new swing low, but the MACD histogram does not, indicating a divergence between price and momentum.

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Figure 2 illustrates a typical divergence trade:

Figure 2: A typical (negative) divergence trade using a MACD histogram. At the right-hand circle on the price chart, the price movements make a new swing high, but at the corresponding circled point on the MACD histogram, the MACD histogram is unable to exceed its previous high of 0.3307. (The histogram reached this high at the point indicated by the lower left-hand circle.) The divergence is a signal that the price is about to reverse at the new high and, as such, it is a signal for the trader to enter into a short position.

Source: Source: FXTrek Intellicharts

Unfortunately, the divergence trade is not very accurate, as it fails more times than it succeeds. Prices frequently have several final bursts up or down that trigger stops and force traders out of position just before the move actually makes a sustained turn and the trade becomes profitable.

Figure 3 demonstrates a typical divergence fakeout, which has frustrated scores of traders over the years:

Figure 3: A typical divergence fakeout. Strong divergence is illustrated by the right circle (at the bottom of the chart) by the vertical line, but traders who set their stops at swing highs would have been taken out of the trade before it turned in their direction.

Source: Source: FXTrek Intellicharts

One of the reasons traders often lose with this setup is that they enter a trade on a signal from the MACD indicator but exit it based on the move in price. Since the MACD histogram is a derivative of price and is not price itself, this approach is, in effect, the trading version of mixing apples and oranges.

Using the MACD Histogram for Both Entry and Exit

To resolve the inconsistency between entry and exit, a trader can use the MACD histogram for both trade entry and trade exit signals. To do so, the trader trading the negative divergence takes a partial short position at the initial point of divergence, but instead of setting the stop at the nearest swing high based on price, he or she instead stops out the trade only if the high of the MACD histogram exceeds its previous swing high, indicating that momentum is actually accelerating and the trader is truly wrong on the trade. If, on the other hand, the MACD histogram does not generate a new swing high, the trader then adds to his or her initial position, continually achieving a higher average price for the short.

Currency traders are uniquely positioned to take advantage of this strategy, because the larger the position, the larger the potential gains once the price reverses. In forex (FX), you can implement this strategy with any size of position and not have to worry about influencing price. (Traders can execute transactions as large as 100,000 units or as little as 1,000 units for the same typical spread of 3-5 points in the major pairs.)

In effect, this strategy requires the trader to average up as prices temporarily move against him or her. This is typically not considered a good strategy. Many trading books have derisively dubbed such a technique as “adding to your losers.” However, in this case, the trader has a logical reason for doing so: The MACD histogram has shown divergence, which indicates that momentum is waning and price may soon turn. In effect, the trader is trying to call the bluff between the seeming strength of immediate price action and the MACD readings that hint at weakness ahead. Still, a well-prepared trader using the advantages of fixed costs in FX, by properly averaging up the trade, can withstand the temporary drawdowns until price turns in his or her favor.

Figure 4 illustrates this strategy in action:

Figure 4: The chart indicates where price makes successive highs but the MACD histogram does not – foreshadowing the decline that eventually comes. By averaging up his or her short, the trader eventually earns a handsome profit, as we see the price making a sustained reversal after the final point of divergence.

Source: Source: FXTrek Intellicharts

The Bottom Line

Like life, trading is rarely black and white. Some rules that traders agree on blindly, such as never adding to a loser, can be successfully broken to achieve extraordinary profits. However, a logical, methodical approach for violating these important money management rules needs to be established before attempting to capture gains. In the case of the MACD histogram, trading the indicator instead of the price offers a new way to trade an old idea: divergence. Applying this method to the FX market, which allows effortless scaling up of positions, makes this idea even more intriguing to day traders and position traders alike.

Moving Average Convergence Divergence – MACD

What Is Moving Average Convergence Divergence – MACD?

Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA.

The result of that calculation is the MACD line. A nine-day EMA of the MACD called the “signal line,” is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals. Traders may buy the security when the MACD crosses above its signal line and sell – or short – the security when the MACD crosses below the signal line. Moving Average Convergence Divergence (MACD) indicators can be interpreted in several ways, but the more common methods are crossovers, divergences, and rapid rises/falls.

Key Takeaways

  • Moving Average Convergence Divergence (MACD) is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.
  • MACD triggers technical signals when it crosses above (to buy) or below (to sell) its signal line.
  • The speed of crossovers is also taken as a signal of a market is overbought or oversold.
  • MACD helps investors understand whether the bullish or bearish movement in the price is strengthening or weakening.

Moving Average Convergence Divergence – MACD

The Formula for MACD Is:

MACD is calculated by subtracting the long-term EMA (26 periods) from the short-term EMA (12 periods). An exponential moving average (EMA) is a type of moving average (MA) that places a greater weight and significance on the most recent data points. The exponential moving average is also referred to as the exponentially weighted moving average. An exponentially weighted moving average reacts more significantly to recent price changes than a simple moving average (SMA), which applies an equal weight to all observations in the period.

Learning From MACD

The MACD has a positive value whenever the 12-period EMA (blue) is above the 26-period EMA (red) and a negative value when the 12-period EMA is below the 26-period EMA. The more distant the MACD is above or below its baseline indicates that the distance between the two EMAs is growing. In the following chart, you can see how the two EMAs applied to the price chart correspond to the MACD (blue) crossing above or below its baseline (red dashed) in the indicator below the price chart.

MACD is often displayed with a histogram (see the chart below) which graphs the distance between the MACD and its signal line. If the MACD is above the signal line, the histogram will be above the MACD’s baseline. If the MACD is below its signal line, the histogram will be below the MACD’s baseline. Traders use the MACD’s histogram to identify when bullish or bearish momentum is high.

MACD vs. Relative Strength

The relative strength indicator (RSI) aims to signal whether a market is considered to be overbought or oversold in relation to recent price levels. The RSI is an oscillator that calculates average price gains and losses over a given period of time; the default time period is 14 periods with values bounded from 0 to 100.

MACD measures the relationship between two EMAs, while the RSI measures price change in relation to recent price highs and lows. These two indicators are often used together to provide analysts a more complete technical picture of a market.

These indicators both measure momentum in a market, but, because they measure different factors, they sometimes give contrary indications. For example, the RSI may show a reading above 70 for a sustained period of time, indicating a market is overextended to the buy side in relation to recent prices, while the MACD indicates the market is still increasing in buying momentum. Either indicator may signal an upcoming trend change by showing divergence from price (price continues higher while the indicator turns lower, or vice versa).

Limitations of MACD

One of the main problems with divergence is that it can often signal a possible reversal but then no actual reversal actually happens – it produces a false positive. The other problem is that divergence doesn’t forecast all reversals. In other words, it predicts too many reversals that don’t occur and not enough real price reversals.

“False positive” divergence often occurs when the price of an asset moves sideways, such as in a range or triangle pattern following a trend. A slowdown in the momentum – sideways movement or slow trending movement – of the price will cause the MACD to pull away from its prior extremes and gravitate toward the zero lines even in the absence of a true reversal.

Additional MACD Resources

Are you interested in using MACD for your trades? Check out our own primer on the MACD and Spotting Trend Reversals with MACD for more information.

If you’d like to learn about more indicators, Investopedia’s Technical Analysis Course provides a comprehensive introduction to the subject. You’ll learn basic and advanced technical analysis, chart reading skills, technical indicators you need to identify, and how to capitalize on price trends in over five hours of on-demand video, exercises, and interactive content.

Example of MACD Crossovers

As shown on the following chart, when the MACD falls below the signal line, it is a bearish signal which indicates that it may be time to sell. Conversely, when the MACD rises above the signal line, the indicator gives a bullish signal, which suggests that the price of the asset is likely to experience upward momentum. Some traders wait for a confirmed cross above the signal line before entering a position to reduce the chances of being “faked out” and entering a position too early.

Crossovers are more reliable when they conform to the prevailing trend. If the MACD crosses above its signal line following a brief correction within a longer-term uptrend, it qualifies as bullish confirmation.

If the MACD crosses below its signal line following a brief move higher within a longer-term downtrend, traders would consider that a bearish confirmation.

Example of Divergence

When the MACD forms highs or lows that diverge from the corresponding highs and lows on the price, it is called a divergence. A bullish divergence appears when the MACD forms two rising lows that correspond with two falling lows on the price. This is a valid bullish signal when the long-term trend is still positive. Some traders will look for bullish divergences even when the long-term trend is negative because they can signal a change in the trend, although this technique is less reliable.

When the MACD forms a series of two falling highs that correspond with two rising highs on the price, a bearish divergence has been formed. A bearish divergence that appears during a long-term bearish trend is considered confirmation that the trend is likely to continue. Some traders will watch for bearish divergences during long-term bullish trends because they can signal weakness in the trend. However, it is not as reliable as a bearish divergence during a bearish trend.

Example of Rapid Rises or Falls

When the MACD rises or falls rapidly (the shorter-term moving average pulls away from the longer-term moving average), it is a signal that the security is overbought or oversold and will soon return to normal levels. Traders will often combine this analysis with the Relative Strength Index (RSI) or other technical indicators to verify overbought or oversold conditions.

It is not uncommon for investors to use the MACD’s histogram the same way they may use the MACD itself. Positive or negative crossovers, divergences, and rapid rises or falls can be identified on the histogram as well. Some experience is needed before deciding which is best in any given situation because there are timing differences between signals on the MACD and its histogram.

Don’t Trade Based on MACD Divergence Until You Read This

The moving average convergence divergence (MACD) indicator is popular among traders and analysts, yet there’s more to using and understanding it than meets the eye. The MACD indicator uses moving-average lines to illustrate changes in price patterns.

When the price of an asset, such as a stock or currency pair, is moving in one direction and the MACD’s indicator line is moving in the other, that’s divergence. This type of signal is supposed to warn of a price- direction reversal, but the signal can be misleading and inaccurate.

Another type of divergence is when a security’s price reaches a new high (or a new low) level, but the MACD indicator doesn’t. Traditionally, this would indicate that the price’s direction is losing momentum and is priming for a reversal. This can also prove to be an unreliable trading signal.
While you don’t need to understand the math that underlies the calculation of the MACD trendlines, by understanding more about how the MACD indicator works, you’ll be better positioned to avoid getting fooled by its false signals or lack of signals, such as when the price turns but the MACD doesn’t provide any warning.

Issues With Divergence After a Sharp Move

Monitoring the MACD technical indicator in relation to price action reveals a few problems which could affect traders who rely on the MACD divergence tool.

A divergence pattern between the two MACD trend lines 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 moves around it.

Price momentum can’t continue forever so as soon 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 divergence is no longer useful. By dropping, while the price continues to move higher or move sideways, the MACD is showing momentum has slowed but it doesn’t indicate a reversal.

In the pictured chart, the EUR/USD is falling, yet the MACD is rising. Had a trader assumed that the rising MACD was a positive sign, they may have exited their short trade, missing out on additional profit. Or they may have taken a long trade, even though the price action showed a significant downtrend and no signs of a reversal (no higher swing highs or higher swing lows to indicate an end to the downtrend).

That doesn’t mean divergence can’t or won’t signal the occasional reversal, but it must be taken with a grain of salt after a big move.

Since divergence occurs after almost every big 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 losing trades.

Problems With Divergence Between MACD Highs (or Lows)

Traders also compare prior highs on the MACD with current highs or prior lows with current lows. For example, if the price moves above a prior high, traders will watch for the MACD to also move above its prior high. If it doesn’t, that’s a divergence or a traditional warning signal of a reversal.

This signal is fallible and related to the problem discussed above. A lower MACD high-price level shows the price didn’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 will cause 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 (more distance covered in less time), then the MACD will show divergence for much of the time the price is slowly (relative to the prior sharp move) marching higher.
If a trader assumes a lower MACD high means the price will reverse, a valuable opportunity may be missed to stay long and collect more profit from the slow(er) march higher.

Or worse, the trader may take a short position into a strong uptrend, with little evidence to support the trade except for an indicator which isn’t useful in this situation.

The chart pictured above shows a downtrend in APPL stock. The downtrend is caused by sharp downward moves, followed by slower downward moves. The sharp price moves always cause much bigger downdrafts in the MACD than slower price moves.

It results in divergence when the next price wave isn’t as sharp, but in no way indicates a reversal. MACD divergence was present this whole day, yet the price dropped all day. If monitoring divergence, an entire day of profits on the downside would have been missed.

Another problem with watching for this type of divergence is that it often isn’t present when an actual price reversal occurs. Therefore, we have an indicator which provides many false signals (divergence occurs, but price doesn’t reverse), but also fails to provide signals on many actual price reversals (price reverses when there is no divergence).

Missed a reversal or breakout? Get in using the Second Chance Breakout Method.

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