Technicals | Nov 29 2012
By Walker England, Trading Instructor
Traditionally traders look to the MACD indicator for its signal line crossovers to identify swing trade entries. While these indicator movements are useful, traders often overlook the imbedded divergence signals that are hidden inside of MACD. If traders know what to look for they can look for, they may use MACD with traditional divergence to spot potential market reversals in the Forex market.
The chart below is an excellent example. The EURJPY has now moved 1061 pips higher after concluding a 1732 decline on the daily chart. Could MACD spot the reversal? To find out, let’s investigate MACD further and its role in spotting traditional market divergence.
(Created using FXCM’s Marketscope 2.0 charts)
What is divergence? Divergence is a market term that indicates that price is separating from the direction of an indicator. In a downtrend, traders will expect that price will moving lower. Since an indicator is nothing more than a representation of what is occurring on the graph the general expectation is for the indicator to do the same. Divergence occurs when an indicator splits from an indicator and they begin heading in two different directions. Let’s look at our example below, again using a EURJPY daily graph.
In a downtrend, we need to begin our analysis by comparing the declining swing lows on the graph. In our EURJPY example we will be comparing the June 1st and July 24th lows, at 95.57 and 94.10 respectively. It is important to note the dates of these points as we need to compare the lows of the MACD indicator as well. Marked on the chart below, we can see MACD making a series of higher lows during the same time period. This is the traditional divergence we are looking for! Once spotted, traders can begin looking for a potential trend change and employ the strategy of their choosing.
(Created using FXCM’s Marketscope 2.0 charts)
Traders should always remember that markets can remain trending for extended periods of time, and that picking trend changes can be very difficult. As with any strategy traders should always use a stop to contain their risk. One method to consider is the use of a tailing stop. In the event of a trend change, traders can continue to lock in profits as a set trail moves forward.
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