Learn MACD Chart Divergence Tactics
The last few days I focused on demonstrating the different parts of the MACD indicator so that you would become familiar with MACD and more importantly less intimidated when analyzing MACD chart patterns. Most beginners have difficulty learning the MACD because it's made up of several parts that interact with one another.
Once you understand how the MACD line is calculated and understand what each of the three parts of the indicator calculate the indicator becomes very simple to understand and moreover to utilize.
Today I will show you another way in which traders use the MACD indicator, the method is called divergence. This is by far the easiest way to use the MACD indicator and one I suggest you start with. The concept of divergence is based on overbought and oversold price levels. Divergence is basically a short term momentum technique to determine when markets are running out of steam temporarily. This method of analysis relies on visual analysis of the MACD line.
Divergence occurs when the MACD diverges from the price of the underlying market. A bullish divergence forms when a market makes a lower low and the MACD Line forms a higher low. Since the MACD Line measures momentum, bullish divergence between the market and the MACD Line suggests that the market may be moving higher despite of the fact that prices are moving down short term.
You can see a perfect MACD chart divergence example of this chart of Hyatt Hotel. Notice the stock begins a strong rally after diverging from the MACD substantially. Keep in mind that divergence analysis works best for reversal formations after markets have been trending for substantial amount of time.
Bearish Divergence occurs when markets are making higher highs and MACD Line is making lower lows. This pattern is the exact opposite of Bullish Divergence and works well after markets have been up trending strongly for extended periods of time. I do not suggest using divergence patterns in range bound markets. The lack of strong momentum will not produce meaningful results when using the MACD indicator. Notice in this particular example how QQQ ETF diverges after a strong uptrend that lasted over 4 months. You always want to see strong uptrend prior to using MACD for divergence.
Here's one more example so you can get a good idea of how the MACD Chart divergence sets up. Remember, you don't have to pay attention to either the Histogram or the Signal Line when analyzing divergence. In this example Apple Computers appears to move higher but quickly heads south a few days after the bearish divergence signal. This set up works well with basic reversal patterns such as double tops and double bottom patterns. I tend to use the MACD as a confirmation indicator when trading these patterns.
In this final example you can see how Bank Of America Stock makes a lower low while the MACD is strongly moving higher at the exact same time; notice it occurs after a strong downtrend as well. The best MACD divergence patterns occur after prolonged trends and momentum moving in one direction.
Divergence analysis is another way to utilize the MACD Indicator. Keep in mind that Divergence only works after sustained trends are coming to an end and exhibited strong momentum in one direction. Also, MACD Divergence works well as a confirmation indicator for other reversal patterns such as double tops and double bottoms. Avoid using the MACD Divergence when trading range bound patterns and when markets are just beginning to trend because the MACD not work well in those types of market environments.
Wishing you the best in your trading and for more on this topic please go to: Short Term Trading Indicators - Bollinger Bands As Trend Filter and Technical Trading Strategies - The Tail Gap Strategy Revisited
By Roger Scott