How To Trade Price Action With Divergence

The Moving Average Convergence and Divergence oscillator (MACD) was first introduced by Gerald Appealin 1979. Even though the concept and construct behind the MACD is straight forward, it is considered one of the most effective momentum indicators available.

The Moving Average Convergence/Divergence Technical Indicator is essentially the difference between a 26-period and 12-period Exponential Moving Average (EMA). To clearly show buy/sell opportunities, a so-called signal line (9-period indicators` moving average) is plotted on the MACD chart.

Consequently, the indicator comprises a MACD line, Signal line and MACD Histogram.

MACD Line: Is the difference between an instrument’s 26-day and 12-day exponential moving averages (EMA).

Signal Line: 9-day EMA of the MACD Line

MACD Histogram: Is the MACD Line minus the Signal Line

Of the two moving averages that make up the MACD, the 12-day EMA is the faster one, while the 26-day is slower. When the shorter moving average pulls away dramatically from the longer moving average, the MACD rises since, it is likely that the security price is over extending and will soon return to more realistic levels.

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 spawns a bullish or purchasing  signal when it moves above its own nine-day EMA, and it spawns a bearish or sells signal when it moves under its nine-day EMA.

Traders as well look for a shift above or underneath the zero line due to the fact that it signals the position of the short-range average as opposed to the long-term average. When the MACD is above zero, the short-term average is above the long-range average, which is an indication of upward momentum. The reverse is the case when the MACD is below zero. The zero line frequently functions as a support area and resistance for the indicator.

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.

The MACD histogram is a graceful illustration of the difference between the MACD and its nine-day EMA. The histogram is positive above the zero line indicated on the right hand side of the MACD when the MACD is above its nine-day EMA or the signaling line and negative when the MACD is below its nine-day EMA or the signaling line. If prices are rising, the histogram gets bigger as the speed of the price action increases and gets smaller while the price action reduces. The same principle works in reverse as prices are falling.  This is exemplified in the figure below:

Price Action MACD Divergence
Price Action MACD Divergence

Observe from the above figure that while the price action or the upper part of the screen accelerates downwards, the MACD histogram indicated by the lower part of the screen achieves fresh lows.

How to trade price action with divergence
How to trade price action with divergence

Simply, when price makes higher highs, the MACD oscillator should also be making higher highs. When this does not occur, the instrument’s prices and the oscillator deviate from each other, suggesting an end to the current trend may be near.

How to trade price action with divergence
How to trade price action with divergence

When price continues to rise to a new high level but the MACD is moving in the opposite direction. The difference of this position from the price action is regularly explained as signal that the trend is about to change. As a result of this may traders use the MACD mainly to determine when the trend is about to change.  Thus, they constantly watch out for such movement diversion from the price action. This is illustrated in the figure below:

Price Action MACD Divergence
Price Action MACD Divergence

The figure above represents a typical (negative) divergence trade with the use of a MACD histogram.

At the right-hand loop on the price chart, the price actions make a fresh high movement, but at the equivalent circled point on the MACD histogram, the MACD histogram did not go above its previous high of 0.3307. The histogram attained this high at the point shown with the lower left-hand circle. That’s why it’s called “divergence.”

The divergence is an indication that the price is about to reverse at the new high, and therefore, it signals for the trader to enter into a short position.

A bullish divergence occurs when the Moving Average Convergence/Divergence indicator is making new highs while prices fail to reach new highs (Blue arrow in above). A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows (Red arrow in image above).

Both divergences are most significant when they occur at relatively overbought/oversold levels.

The two main classes of MACD divergence are:

  • Regular or Classic Divergence
  • Hidden Divergence

Each of the above two types of MACD divergence is further classified into two: bullish or bearish divergence. This gives rise to the following types of MACD divergence:

  • Regular Bullish Divergence
  • Regular Bearish Divergence
  • Hidden Bullish Divergence
  • Hidden Bearish Divergence

These four divergence types are exemplified in the chart below:

Divergence Types
Divergence Types

Trading price action with divergence conclusion

Divergence in an uptrend occurs when price makes a higher high but the indicator does not. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not. When divergence is spotted, there is a higher probability of a price retracement. In summary, trading divergence can be an effective addition to your trading strategy, especially if already using indicators like RSI or CCI to find overbought and oversold levels but should not be replied on by itself and requires practise to get it right.

Hopefully you now have a basic understanding of trading price action and divergence together. If you are looking to trade forex online, you will need an account with a forex broker. If you are looking for some inspiration, please feel free to browse my best forex brokers. I have spent many years testing and reviewing forex brokers. IC Markets are my top choice as I find they have tight spreads, low commission fees, quick execution speeds and excellent customer support.

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