When I started trading as a beginner, I came across an indicator which is called MACD. The indicator may trigger a signal when there is a divergence.
You can spot MACD divergence by observing the price of the stock, and compare it with the MACD indicator. If the stock is making new highs, but the MACD is making a new low, we call this bullish divergence. However, if the security is making a new low but the MACD is making a new high, then that’s a bearish divergence.
The real question is, how can you use this indicator? You can use it for your mean reversion strategy. But be careful, based on my experience I had a lot of bad experiences with this indicator.
MACD divergence indicator measures the momentum of a trend. The trend can be either accelerating or decelerating at the current candle, which is useful for trend-following traders. Because it is a trend following indicator, the indicator is not reliable when the market is consolidating.
The reliability of the MACD indicator is usually lower when the stock price is moving within a range for a longer period.
Bearish Divergence Definition
Bearish divergence is a signal for finding or spotting an early sell signal. An early sell signal occurs when the price makes a higher high; however, the MACD indicator shows a lower high. The lower high usually signifies slowing down of the price momentum.
The slowing down of the price momentum may not stop the price from going up. It happens because although there is a divergence in price, it may not guarantee a price reversal.
Look at the chart below. It shows an example of a MACD divergence.
MACD bearish divergence is usually an early signal for a coming price selloff. The sell signal is often near, and traders should prepare for a possible high probability short trade. However, it is important to understand the bigger trend before taking any trades.
The bigger trend may give context as to what types of direction a trader should follow.
For example, selling stocks only on a downtrend and never taking long trades.
MACD Bullish Divergence
MACD bullish divergence is a buy signal that occurs when the price makes a lower low, yet the MACD is having a higher high. When MACD is having a higher high, there may be a change in the strength of the momentum. This change can signal a reversal of trend, which can carry the price up.
The signal is usually an early indication that shortly there is a possible trade. It possible only because MACD is not always reliable.
How to Spot Divergence?
- Attach MACD indicator in a chart
- Draw trend lines in price to understand the context of the trend. If the price is making higher high, draw it above the price. Otherwise, the lines should be below the price.
- Draw trend lines in the MACD.
- Finally, identify if it is a bearish or bullish divergence.
I don’t use divergence in MACD alone anymore because it doesn’t have an edge when used alone in the market. But some traders believed that it still has potential in the market.
If the indicator is useful on its own, anybody can use it and get rich fast. But, it is not usually the case.
When I started out, I was under the impression that MACD is the holy grail. What happened?
I lost a lot of money!
Here is what I learned.
- MACD divergence does not confirm the movement of price. (source)
- Often signals a reversal but no actual reversal occurs.
- MACD does not function well in sideways markets.
MACD false signals have caused a lot of losses among traders. The losses are mostly the result of using the divergence signal without confirming it with other trend indicators. Trend indicators such as RSI and ALMA can enhance MACD.
Who Created MACD?
Gerald Appel created the indicator in the 1970s. He designed it to reveal changes in the strength, direction, momentum, and duration of the trend in a stock. (source)
Haven’t you notice anything? To reveal, to see after the fact!
It means that the indicator produces a lagging signal. Why on earth would you want to use it? (I mean divergence in MACD)
The most common setting is 12, 26, and 9. Number 9 is simply the average of the difference between 12 and 26.
How is MACD calculated?
MACD is the difference between two exponential moving averages. Does that mean anything to you?
Also, I don’t think it means anything. Are you going to depend on an indicator that has no real value?
The zero lines signify that there is no difference between the averages.
For example, if MA12 is equal to MA26, then MACD is equal to 0.
Why it is Unreliable?
MACD is unreliable if you used it solely to spot divergence because it has been designed to only reveal the direction of the trend.
MACD Divergence Strategy
This MACD divergence strategy is unique because it utilizes the power of both MACD and RSI indicators. MACD will spot the occurrence of divergence, and RSI will detect when there is a trend. Both indicators will have the default settings to generate reliable signals.
- MACD = Bullish divergence
- RSI is above 50
- MACD = Bearish divergence
- RSI is below 30
The range of the other indicator determines the trend of the stock. The trend is usually detected if it is outside 30 to 50.