Moving Average Convergence Divergence, short for MACD indicator, is a famous leading indicator developed by Gerald Appel in 1979. This MACD divergence indicator consists of a histogram and an exponential moving average, widely applied to track the trend momentum like every other leading beacon. Nevertheless, hiding behind this powerful indicator is a countertrend trading system called MACD Divergence, which is considered one of the most effective knife-catching strategies by professional traders.
MACD indicator explained
MACD indicator is a multifunctional technical tool that measures the trend pulse, indicates the direction of price change and shows potential reversals. It consists of three components with an effective combination of mathematical formulas. The full name of the tool is Moving Average Convergence and Divergence. The main idea is based on several smoothing layers of sharp price fluctuations to estimate the current trend from several points of view.
The MACD trend indicator looks like this:
How to read MACD indicator?
MACD Indicator has three values and three settings for each of them. The bar graph measures the trend pulse and shows the dominance of bulls or bears. If the histogram changes its position relative to the zero line, then the trading conditions may change. The other components of the indicator are the MACD line and the signal line. Crossing these lines usually indicates a change in technical settings.
What is MACD divergence?
MACD divergence occurs when the trend continues in the previous direction, while the MACD indicates that the momentum is weakening. In other words, the trend does not have the same strength as before, prices show fewer rises or falls compared to the previous period and the opposite movement becomes more likely. For example, if an uptrend kept a sequence of higher highs but the MACD lines showed lower peaks, then the divergence would indicate that something is wrong with the current trend.
The mathematical basis of the divergence is hidden in several formulas. The main idea is to compare the change in exponential moving averages with different periods and apply additional smoothing to the difference in peaks and drops. As a result, the indicator measures the relative rise or fall of the price distributed over the selected period.
Bullish divergence MACD
The bullish divergence of the MACD occurs after the downtrend loses momentum. The price chart still has lower lows as the bears still control the market. However, the indicator lines show higher lows in the same period, while their direction is towards zero levels, reflecting the weakening momentum.
Here's an example:
The screenshot shows that the NZD/USD was in a long-term downward trend for the daily period. At some point, the downtrend slowed down, the number of consecutive red candlesticks decreased, and the downward oscillations narrowed the bearish range. Although the pair continued to draw lower lows indicating a bearish continuation, the MACD lines rose to higher lows, causing a bullish divergence. The bullish divergence of the MACD showed a downtrend reversal and the beginning of a new uptrend.
Bearish divergence MACD
The bearish divergence of MACD is a mirror image of the previous example. It occurs after a steady upward trend, when bulls start to lose momentum. The best way to detect bearish divergence is to find a period when prices continue to make higher highs, while the MACD lines indicate lower highs. The period between highs has clear signs that the previous uptrend is slowing down and could lead to a long-term bearish reversal or pullback.
Here is an example:
As the daily chart shows, the gold price had a steady up trend. After reaching a certain level, the uptrend began to slow down, the depth of the bearish rebound increased, and prices could not rise as before. Although there were growth peaks (higher highs) on the chart, the MACD indicator drew lower highs. The bearish divergence of the MACD caused a long-term reversal, as the price of gold fell from $1550 to $1460 per ounce.
How does MACD divergence work?
Above all, readers could notice that MACD divergence is used for long-term analysis. Strong trends generally do not change for no reason, and there should be a rebalancing period before the counter trend starts. That is why it is important to keep an eye on secondary factors that influence price movements. The fundamental background is crucial for asset prices in terms of trading conditions. If economic drivers no longer support the previous trend, market participants lose interest in continuing in the same direction as before.
In terms of technical analysis, the depth of a short-term correction is important within the limits of trend stability. If, for example, the uptrend had deeper rebounds compared to the previous development, analysts would conclude that the bears are becoming more active, even if price continues to rise. Another secondary metric for monitoring is the MACD histogram. Forex traders should follow not only the lines, but also the histogram. If it crosses the zero level, changing the color several times, the technical mood changes.
The technical trigger should take place before prices start moving in the opposite direction. In this case, the most important trading signal is crossing the MACD lines marked in the indicator window. Even if both lines are moving in the opposite direction compared to the price action, but no crossover has occurred, the divergence pattern of the MACD may only indicate a temporary slowdown of the recent trend, not a reversal. Consequently, the absence of a trigger does not trigger the pattern, and the trend turns into a sideways consolidation.
Finally, the MACD divergence pattern is considered complete when the lines cross the zero level. In most cases, they continue to move in the same direction above or below the threshold, and action against the trend continues, however, this movement is due to market inertia and does not necessarily mean further trend development. Thus, the divergence is considered to be worked out when the MACD lines cross the zero line. Here is a complete list of conditions for market entry according to the MACD divergence strategy.
Examples of profitable trading
Two examples of profitable positions using the MACD indicator strategy are already shown above. Both of them brought a good profit, although the cycles were short-term. There is also a method based on technical analysis aimed at maximizing profits from Forex trading, increasing the duration of profitable positions and improving the efficiency of the trading system. The disadvantage of strategies based on one indicator is that discrepancies cannot lead to a sharp price movement against the trend, the impulse of weakening is accompanied by lateral consolidation, and the previous trend continues in the same direction. Traders who entered the market with such a scenario may not get the desired result in the form of several profitable deals in a row or even suffer losses associated with false trading signals.
The solution is to add another layer of analysis thanks to the secondary indicator. Since MACD indicator is a rather slow and lagging indicator, a fast and sensitive tool can help to increase the efficiency of a trading strategy, increase profits and reduce the number of false signals. Relative Strength Index is one of the most widely used oscillators combined with MACD to highlight its strength and smooth out weaknesses. RSI also has bullish and bearish divergences aimed at confirming the signal from the MACD or shifting the beginning of the trading cycle to the ideal moment when prices start moving in the right direction. Here are some examples of how to combine MACD divergences with an RSI oscillator in forex trading.
Trading after RSI confirmed the bullish divergence of the MACD
MACD diverged from the EUR/USD chart for quite a long time, and even several buy signals appeared, but the reversal did not happen. As soon as RSI confirmed the divergence and provoked the beginning of a sharp rise, the trading position for buying brought a significant profit. The combination of the MACD and RSI indicators also helped to detect the opposite signal to exit the market when the MACD lines made a bearish crossover, while the RSI came out of the overbought zone.
RSI after MACD bearish divergence
The daily chart below shows EUR/JPY in a long-term upward trend. Prices continued to rise at some point, but the MACD lines began to decline. The bearish divergence had three peaks, while the RSI oscillator highlighted the ideal entry point after the rebound with a sequence of descending peaks.
Pros and cons of the strategy
- Easy-to- use, general-purpose;
- Generating highly reliable trading signals;
- Helping trader catch a whole new trend;
- Not necessitating traders to keep eyes on the trading platform.
- Requiring a high level of patience;
- Containing risks of a counter-trend strategy.
If you like this strategy, you might also be interested in this Reversal Trading
Despite the fact that trend-following is the most effective trading principle, the “Divergence MACD” system, with advantages mentioned above in addition to a good testing result, has shown itself to be a profitable strategy. However, as a counter-trend strategy, it still carries potential risks. We suggest that you should only use this strategy given being proficient in technical analysis. Besides, risk controlling and psychological managing methods are also required.