One of the most popular tools used for technical analysis is MACD, the Moving Average Convergence-Divergence. It is a part of every charting package, included in every analytical software and explained in just about all books ever written on TA. Exceptions are the few books published before the explosion of technical analysis in last couple of decades. Edwards-Magee book “Technical Analysis of Stock Trends” is one of them. Point is, MACD is very popular, well known and available everywhere.
There are many ways to use it. One of them is spotting divergences between MACD and price of the financial instrument. For example, price makes new high, but indicator does not, it is a divergence. If this happens, conditions created are called “overbought” and suggest possible change in price direction. Opposite happens at the other extreme- low prices. Divergences are very often shown by promoters of trading systems and signal providers as a “proof” of how easy it is to make money trading. They are virtually always pointed out with a benefit of a hindsight. “You could have bought/sold it here and made millions” or something like that. Yes, they are easy to see once already established, which is after the fact and useless, but not really that simple while forming.
One of the myths regarding MACD divergences is that they predict market reversals. Wrong. They suggest oversold conditions, which could lead to price pull back or bounce, depending on direction, not an all out trend change. This is important difference, because it helps determine objective for trades. And yes, sometimes it will lead to trend reversal, but this is not a promise of this trading concept. Such is my experience. Another big problem is choosing correct entry point while divergence is being formed, which is always a little subjective, even if solid rules are created. Also, depending on how the the price behaves leading to emergence of signal, it will have a higher or lower probability of success from the start. Divergences have certain discernable characteristics, which lead to higher or lower failure rate. This concept and nuances involved could fill a small book and are little too much for this blog.
In my trading MACD divergences play secondary role. Price action and swing trading are always primary tools. However, few years ago I used this strategy extensively and had decent results. During the process I accumulated thousands of charts of divergences on all time frame and conducted massive study on the subject. To this day I use them periodically as an additional confirmation tool to my analysis. Current situation could make them useful.
Yesterday, Yen pairs were discussed. Daily charts indicate strong resistance and price corrections. Interestingly enough, we also have MACD divergences present on this same time frame. One of them is CAD-JPY, featured in last post.
Daily candle formed yesterday closed as a “dark cloud cover”a bearish reversal pattern, something I had been looking for. Also, price made a new high, while MACD didn’t- this is a divergence. This is the point when anybody looking using this strategy must look for entry signal. For me this was it- the reversal candle. I sold CAD-JPY at 88.72, with divergence being a confirmation, not the reason for selling. Just like explained above, I’m not looking for an all out trend reversal but a correction. Most corrections tend to end up within a band made of 38-62 FIB numbers, so my objective is 85.00 for now. Risks are small, just above yesterday’s high. I must point out, that the shape of price does not fit “perfect” model, so the divergence itself is not extremely strong, but combined with everything else, this trade presents good opportunity.
AUD-JPY is another of Yen crosses showing a divergence on daily chart. Here it is more pronounced, as the difference between the tops is bigger in MACD. Unlike previous example, we see this pair didn’t have a reversal candlestick pattern yesterday. However, if today closes as a bearish candle, this could act as a more complex formation. Sell would be under today’s low, which, right now, is still unknown, but should be around 79.30. Objective size is very similar to CAD-JPY, at around 76.00 and reasonable risk.
The beast had a strong day so far and is not showing a divergence. Yet, it could happen tomorrow, or not happen at all. I wouldn’t be taking another trade in one more Yen pair, at the same time based on the same reasoning, because it would be a lousy feeling if I’m wrong. However, sell signals using smaller time frames will surely be a play. At any rate, GBP-JPY deserves its own analysis. I know, I know, it was mentioned before, yet still no post devoted to this pair. It’s just that new stuff keeps coming up and takes precedence, but I’ll try.
Mike K.
Spread Trading Madness
Spread trading can make you money in a maddening global financial market.
Spread trading is an alternative to traditional share buying and selling,
and there are ways and means to protect your investment against market fall.
[...] Original post by fxmadness.com [...]
Thanks, Mike. This is precisely the kind of info I’m looking for. As far as the stop goes for divergencies, is it always best to put them just above the high/below low? Isn’t it too tight?
Very, very interesting. What are the “characteristics of winning divergences” you mentioned? How complex is it?
[...] Original post by fxmadness.com [...]
Maxim, you are right, Stops are tigh, well one stop for the trade that is live now. There are at least 2 other methods for setting stops here. I chose this one, as small as possible, because long term I’m bullish these pairs. This means that current play is a little “against the grain” and that’s why I’m extra carefull here. Makes sense?
Grace, that would demand some explaining and best number of examples on charts. It is not very complex in itself, but not something that can be sufficiently discuss here. Would probably need 2-3 full posts. I might do it in the future if there is enough interest.
Gbp- jpy also looks ready to reverse.How come you don’t want to short it like the others?
Like stated earlier, they would all be too similar. If GBP-JPY starts to fall, I might try to catch some of it on smaller time frames. It hasn’t turned yet, so no action.
Hey Mike – welcome back hope the vacation was excellent, thanks for the update, will be watching AUDJPY, GBPJPY this evening..and Trichet and BOE later on
Bill Cara, a very good trader, came out with an opinion on the dollar. IN short, the dollar is going up. Usually opinions are a dime a dozen, but this is one of the people who trades for a living and made the calls to back it up.
http://caracommunity.com/content/caras-commentary-community-chat-wednesday-aug-5-2009
Vlad
Hello Mark, vacation was great, thank you. JPY is, well, being JPY and does whatever it wants. How is trading?
Vlad, one can produce reasons for both sides of this issue easily. But yes, IF stocks world wide fall, dollar will likely rise, IF commodities fall dollar will probably appreciate. And yes, the interest rates in US will have to go up. However, will they be competitve with other countries?(interest rates are low just about everywhere, so when they spike it will be across the globe.)
Problem to any of this is timing and time frame. Unless we put time constrain to any such claim, they are all very debatable. Both ways.
Like right now AUD-USD and NZD-USD look rather overdone and ready for correction, while EUR-USD seems to be preparing another swing up on daily chart.
USD is surely not dead. For all the talk about about BRIC, SDR’s, gold and what not, at the moment we don’t have a ready made replacement. But US government has clean up its act as far as future spending is concerned. And soon.
I’m hangin’ in there..working on consistency and reducing impulse trades
[...] before slowing down a little bit before the close. I had a sell order for AUD-JPY, as explained in MACD divergences. It was placed just before the low of that day, 79.30. Price didn’t return to this level and [...]
[...] days ago I started to to short JPY pairs based, in part, on daily MACD divergence shown on some of these charts. Well, I decided to take a loss, when the turn around didn’t [...]
[...] of weeks concept of MACD divergence was discussed here. I used daily chart CAD-JPY to illustrate the principles. Divergences can be [...]
[...] hours later, for a loss of 22 pips. Laughable number when trading this cross. Later on very nice MACD divergence formed on hourly chart and I took that trade. Price made new low, while MACD didn’t. Went [...]
[...] by few pips. MACD is far behind and the total picture has great characteristics that I look for in MACD divergence trades. With one notable exception- not new price extreme, high in this example. It is possible that other [...]
[...] to Yen pairs. Intermediate term chart indicate possible overbought levels, with MACD divergences easily visible. I shorted EUR-JPY at 123.55, looking for 100 pips. Not much for ether this pair or time frame, but [...]
[...] example, virtually all divergence strategies are hoping for a false breakout. Price makes new high or low, but indicator used in the analysis [...]
Keep posting stuff like this i really like it
[...] for Wednesday turned out to be a doji, a possible reversal pattern. On top of this, the price and the MACD form a divergence. While the divergences to not mean an all out trend reversal, they increase a probability for a [...]