Some traders regard MACD divergence as a Forex signal to enter a high probability trade. They almost suggest you get straight in to a trade as soon as you see MACD divergence.
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Is this Forex signal that reliable? To be fair, it certainly has a place in a successful trader’s kit of strategies, but as with any Forex signal, there are certain precautions that have to be observed to make any trade high probability.
At this time there doesn’t appear to be any Forex signal that offers anywhere near a 100% success rate.
So if you are tempted to trade on the basis of MACD divergence, what other factors should you keep in mind?
MACD Divergence Defined
First let’s just spell out exactly what is meant by MACD divergence.
MACD (Moving Average Convergence Divergence) comes as a standard Forex signal on all the main charting packages. Some show MACD by itself with two lines, one a combination of a 12 and 26 Exponential Moving Average, and the other line based on a 9 Exponential Moving Average.
Some charting packages also include what is called a Histogram in the same charting area as MACD. The histogram merely represents in a different way what is happening between the two MACD lines as to market momentum. The wider the gap between the MACD lines, the higher or lower the height of the histogram bars.
To identify MACD divergence, simply draw a line across the highs if MACD is above the zero line, or draw a line across the lows if MACD is below the zero line.
Now go to the price action section of the chart, the candlesticks, and draw a line across the highs directly above where the line is drawn on the MACD highs, or draw a line across price lows directly above where the line is drawn on MACD lows.
If they are going in opposite directions you have MACD divergence. In other words, when MACD is making lower highs and lower lows but price is making higher highs and higher lows, this negative MACD divergence forms a Forex signal indicating price could well start to drop.
If MACD is making higher highs and higher lows but price is making lower highs and lower lows, this positive MACD divergence forms a Forex signal indicating price could well start to rise.
MACD Divergence Precautions
Be aware that MACD divergence on a smaller time frame is not so significant. When it is seen on a 15 minute chart it may or may not be very important.
If seen on a 60 minute, 4 hour, or daily chart, start doing more analysis.
If you see MACD divergence on two or more of the higher time frames, then definitely sit up and take notice and start looking for other factors to indicate when price may react to the divergence.
This brings us to a key point when trading MACD divergence as a Forex signal to enter a trade. On a higher time frame, MACD divergence can be a fairly reliable indicator of a change in price direction. However, the big question is: WHEN?
Many traders get caught out by entering a trade too soon when they see MACD divergence. In many cases, price has still got some muscle to continue in the current direction. The trader who has jumped in too soon can only stare at the screen in dismay as price shoots through his stop taking him out.
How Can This Scenario Be Avoided
Before pulling the trigger when you see MACD divergence on the higher time frames, be sure to look for other key Forex signals to confirm that the divergence has really kicked in.
For example, if you see a distinctive candle pattern such as a tweezer top or a hanging man on the higher time frame it may appear price has topped out and is now ready to move in the other direction.
If at the same time the distinctive candle pattern is at a key level of previous support or resistance, or at a pivot level, or a Fibonacci retracement or extension level, you have added reason to believe this could well be a turning point and put an entry order in at this level to get taken in.
At the same time, you will want to consult your trading calendar to make sure you are not entering a trade near a significant Fundamental Announcement. Even though the MACD divergence may kick in soon, the Fundamental Announcement could cause a major spike in price and take out your stop.
So in summary, is MACD divergence a high probability Forex signal?
Answer: By itself NO!
How can MACD divergence be used safely?
Answer: Check to see if MACD divergence is seen on one or more higher time frame charts such as the 60 minute, 4 hour, or daily.
Then look for other Forex signals such as candle patterns, support or resistance levels, or Fibonacci retracement extension levels.
In other words, use MACD divergence as a confirmation Forex signal that you are going in the right direction rather than a stand-alone Forex signal.
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