How to Trade the MACD Divergence Part 1
Divergence can be one of the more powerful signals in your trading arsenal if used correctly. Today we'll look at the MACD and the divergence signals it produces, and we'll use the most common settings for the MACD which are 26 for the Slow EMA, 12 for the Fast EMA and 9 for the MACD SMA.
Divergence just like the name says, occurs when price and an indicator (in our case the MACD histogram) diverge, either price goes up and the MACD goes down or reverse. There are 2 types of divergence, regular and hidden, the difference being that hidden divergence indicates possible trend continuation while the regular divergence signals a possible reversal of price. Today we'll look at the regular MACD divergence.
On the chart below we can see an excellent example of a MACD divergence on the EUR/USD 1 hour chart that happened very recently on Friday, August 17.
Notice how as the Euro makes a new high the MACD histogram keeps printing new lows. This indicates a possible trend reversal. When you see this divergence happening, you can play it in 2 ways, via an aggressive or a conservative entry. The aggressive entry doesn't wait for the MACD histogram bar to close down to confirm the downward direction of the price but enters right away.
This has its pluses and minuses, the main drawback is the risk. Since the MACD histogram has not yet confirmed the direction down, there is a higher risk of price going up or stalling. The main plus of such entries is the lower risk. Since you will be entering earlier you may get a better price thus keeping the risk lower and the reward higher leading to a better risk to reward ratio, that may compensate for the lower win percentage. However keep in mind that aggressive entries require lot more experience to trade and are not recommended if you're relatively new to trading divergence.
The conservative entry waits for MACD confirmation
Under the conservative entry we would wait for the MACD histogram to head down and thus confirm the signal down. In the chart above notice how at 12:00 the MACD histogram closed higher then the previous bar while price also spiked higher. We get a confirmation for a conservative entry when the MACD closes down at 13:00. The EUR/USD pair closed the 12h bar at 1.2367 but was trading lower at 1.2359 at 13:00, at the time of the conservative entry. In this case, you may have gotten a better price with the aggressive entry although that's debatable because we can't see how the MACD and price behaved between the open and close of the 1h bars. From the conservative entry at 1.2359 the Euro fell 71 pips in the next few hours. Keep in mind your 1h charts may differ from mine depending on what broker you use and their server time.
In the other parts we'll look at that the conditions under which the MACD divergence works best and also look at the situations where it fails miserably. We'll also look at ideas where to put the stop loss and take profit orders. Until then experiment with spotting the MACD divergence on your charts and maybe test it out on a demo account.