MACD Divergence

MACD (Moving Average Convergence/Divergence)

There are numerous ways how to trade MACD in the direction of current trend (read more about MACD crossovers). Though MACD is built on exponential moving averages, which make many people immediately think about trend following, there are also ways to use the MACD for counter-trend trading and spotting probable reversals.

Trading overbought/oversold market with MACD

Thought officially the MACD indicator has nothing like overbought and oversold levels and the values it can reach are not limited by any certain number, it is possible to use the MACD for identifying when the market’s momentum may be overheated on one side or the other.

However, it is quite difficult to define hard fixed rules for such strategy. Trading it successfully requires a good familiarity with the behaviour of the market you trade – especially knowing which MACD levels are usually too far away from the zero line and might therefore signal high probability of a pullback towards it (a correction in the current trend).

Even then, you will likely find trading this MACD counter-trend system very difficult on a standalone basis – for trade entries, this way of looking at MACD may better serve as a supporting or confirmation tool in addition to some other technical analysis tools.

Using MACD for exiting positions

Nevertheless, counter-trend MACD trading signals may be interesting as a strategy for exiting positions. For example, you can buy pullbacks to a moving average and then exit the trade when MACD line gets too high (and then wait for prices to come back to your moving average to buy again).

Trading MACD Divergences

MACD divergences are considered one of the most powerful ways to trade with MACD. The idea of a divergence is the same with many other oscillators (like RSI, Momentum, or Stochastics).

Divergences exist on both sides – there are bullish divergences and bearish divergences. A bullish divergence occurs when market (price) makes a new low (lower than the previous low), while the MACD line’s new low is higher than its previous low. Therefore the MACD is diverging from the price, questioning the strength of the prevailing price downtrend (it indicates that the bears might be losing power). When you see a bullish divergence on the MACD line, it is a signal to buy, as the probability of a trend reversal is high.

On the other side, a bearish divergence indicates a probable end of uptrend and occurs when the price makes a new higher high, while the MACD line’s new high is lower than the previous one. It is a sell signal.

Divergences on MACD Histogram

You can also identify and trade divergences on the MACD Histogram, which is the difference between the MACD line and the Signal line. Interpretation is the same as with MACD line divergences – there are bullish divergences and bearish divergences. Bullish divergences occur when price makes a lower low and MACD Histogram makes a higher low (buy signal), while bearish divergences occur when price makes a new higher high, while MACD Histogram makes a lower high (sell signal).

MACD Histogram divergences: as strong as you make them

Many people say that MACD Histogram divergences are stronger than MACD line divergences and that they are one of the most powerful signals in technical analysis. It is true that you will not see MACD Histogram divergences very often and once they occur, the probability of a trend reversal is high (though far from 100%). Regarding profitability and reliability, MACD Histogram divergences are no different from anything else – it only depends on how you make them work in your particular market and time horizon.

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