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Richard Krugel

pro MEMBER SINCE 2018

Richard is a full time trader with 12 years experience that includes working as an equities day trader at a trading floor in Cape Town.

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15 min read 7th of Oct, 2019
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MACD divergence trading strategy

One of the most popular indicators available to traders today is the MACD, which stands for Moving Average Convergence Divergence. In this trading guide, I will show you how the MACD can greatly improve your accuracy when making trading decisions, and how I incorporate this powerful indicator in conjunction with other analytical techniques.

Beginner traders often make the mistake in thinking that the more indicators they have the better their results will be, but this is not the case. Using too many indicators, or not knowing which indicators to use in combination with each other, can cause sensory overload, confusion and generate false signals.

This guide will hopefully prove to you that less is often better, when it comes to trading and how you can only use one indicator, like the MACD to improve your trading skills.

Overview of Indicators

Traders rely heavily on indicators to assist them with their technical analysis and there are many variables used to calculate an indicator’s values which are mostly based on the open, high, low, close and volume of a candle or bar.

These variables have led to the creation of thousands of indicators, but they all fall into 4 types or categories which all aim to achieve one particular goal:

  • Trend Indicators
  • Momentum Indicators
  • Volatility Indicators
  • Volume Indicators

The MACD is listed under the momentum indicator category and is typically used to spot a condition called Momentum Divergence, which we will look at in greater detail later.

The MACD Indicator

On the chart above, I have attached a MACD using a 4-hour timeframe on Gold, as an example.

The MACD is constructed using 3 variables:

  • The first is the standard MACD (which on my chart is coloured in blue) and this line is calculated using the closing prices of a 12-day exponential moving average (or EMA for short), minus a 26-day EMA.
  • The second variable is the orange line on my chart which is called a signal line and it is calculated using a 9-day EMA that is plotted next to the MACD line, and it signals turns in the indicator.
  • The third part is called the MACD-Histogram which shows the difference between the blue MACD line and the orange signal line and it is plotted in green and red, either above or below a zero line. (Your charting software might give you different colours as a default, but in this guide, I will just stick with my default colours using Trading View).

Now, look at what happens when the MACD line and signal line cross each other (red circles). When the MACD is above the signal line the MACD-Histogram plots above the zero line and vice versa when the lines cross each other the other way around.

Traders will typically use the signal line as confirmation to enter into a trade.

That, in short, are the variables that make up the MACD and I know that a lot of newbie traders will have questions about which settings to use etc. I tend to simply use the standard default settings and as you will see later, they work perfectly fine with no changes made to them.

Momentum Divergence

One of the more common uses of the MACD is to spot a condition called Momentum Divergence because it can forewarn a trader when a trend might be coming to an end before it reverses into the opposite direction.

The momentum of price movement can be defined as the force at which price is moving in any particular direction. The start of trends will normally begin with an increase in momentum but as a trend matures, or comes to an end, then the momentum at which price was moving tends to dry up before a change in direction occurs.

The chart above shows an upward trending market and by using a MACD-Histogram we can see that as price accelerated upwards (green arrows), so did the green histograms become larger and larger (above the zero line). Price then reached a point (on two occasions) where a correction occurred, but this time around the histograms showed a decrease in momentum as they became shorter and shorter (closer to the zero line).

This phenomenon shows that momentum, as displayed by the MACD-Histogram, started to dry up as price continued its way upwards. This is known as price and momentum divergence i.e. price and momentum started moving in opposite directions.

Important Note

There is one big problem with momentum divergence indicators though, and that is that they can show divergence from price over a long period of time in a strong trending market, rendering this indicator almost useless when trying to determine the ends of very strong trends.

The MACD-Histogram should therefore, in my opinion, not be used on its own but in combination with other methods of analysis to make better trading decisions. I will show you later how I incorporate the MACD as part of a systematic trading strategy.

Introduction to Market Geometry

Now that we have touched on the basics of how the MACD is constructed and looked at how traders often use this indicator to spot momentum divergence, I would like to introduce you to Market Geometry before we get to the strategy side of this guide.

What is Market Geometry?

Market Geometry works on the principle that there is an underlying symmetry in price behaviour and finding ways to “measure” or define that symmetry using drawing tools is called Market Geometry.

One such drawing tool is called the Alan Andrews Pitchfork and when used correctly, it can help define future price movement, both in the most likely direction a market may take and where price is most likely to find support/resistance in the future.

Tip: Pitchforks work particularly well when applied to corrections, as they often help to determine likely areas where a corrective pattern might end.

Introducing the Pitchfork

There are three types of pitchforks available; namely the Standard, Schiff and Modified Schiff Pitchforks. I only use the two most common ones, which are the Standard and Schiff pitchforks and I will explain them both in detail below.

1. The Standard Pitchfork

Pitchforks generally consist of three lines, called median lines. On the chart above you will see that the centre line is called the Median Line and the two lines above and below the median line are called the Upper Median Line and Lower Median Line.

When I perform my analysis, I add two more lines above and below the upper/lower median lines and they are called Warning Lines (in red).

To draw a pitchfork, the user needs to select three anchor points that will slope the pitchfork lines into the direction of the market. On my chart, the first anchor point was an important high, the second anchor was a lower low, followed by the last anchor point that was a lower high.

Using those anchor points allowed the pitchfork to contain price within the boundaries of the median lines, until price reached the lower median line for the first time, after which a change in trend occurred.

Tip: Standard Pitchforks work well to define strong trending markets because the angle at which the median lines are tilted towards is very steep.

2. The Schiff Pitchfork

Next up is the Schiff Pitchfork, but unlike the Standard Pitchfork, the Schiff Pitchfork has a much flatter angle or slope. To draw a Schiff Pitchfork the user will have to select three anchor points again, but notice this time around that the median line does not start from the first anchor point, but that it is rather angled mid-way, or 50% between, the range of the first and second anchor points.

Notice what happened when price reached the lower median line for the first time. Yes, a change in direction occurred, but in this case a change in direction after a correction.

Tip: Schiff Pitchforks work particularly well when applied to corrections because corrections tend to be less steep in angle than a trend would be.

Using the MACD-Histogram as Part of a Strategy

Now that we have covered the pitchfork it is time to show you how I find trades and how the MACD has become such an integral part of my trading decision making.

Strategy Overview

When I trade, I try to achieve one thing only; that is to find the end of corrections within a trend. You might have heard the term: “The trend is your friend” before? Well, if you have a way to find the end of corrections within a trend, then the path of least resistance would be to trade with the trend and not against it when a correction comes to an end.

That is exactly what I try to achieve, but to do that I use a combination of multi-timeframe analysis, trend identification, Market Geometry and yes, a MACD.

Next, I will run you through the steps that I follow, which has allowed me to pinpoint low risk, yet highly probable trade setups on any market.

Step 1: Trend Identification

Since I want to be trading with the trend, I need to determine what the direction of a trend is first, as well as when a trend might be coming to an end.

The chart above is that of Crude Oil on a 4-hour timeframe and I used very basic trend lines (in blue) to show me the direction of the trend. Price was also making higher highs (HH) and higher lows (HL) which is typical of an upward trending market.

After the high that formed on the 23rd April 2019, price started moving lower, breaking my trend lines and previous market structure (red horizontal lines). This occurrence warned me of a possible change in trend and it switched my bias to the downside.

Step 2: Corrections and Market Geometry

My next step was to anticipate where corrections might appear. After price created the first lower low (LL) and lower high (LH), I used my Fib Extension tool to project levels, to the downside, where I would expect support to come in, followed by a possible correction.

Look at what happened when price reached the 100% and 1.618% Fib Extension levels. Support came in, and on both occasions, price started correcting higher.

Once I had confirmation that a correction was underway, it was time to use my Schiff pitchfork. Since corrections typically move in zig-zag patterns, I like to label my corrections as A-B-C or different variations of that.

Rather than worrying about the exact swings to use when labelling corrections, I let my pitchfork act as a guide, so that I can identify an area where I would expect such a correction to end. In this case, the correction ran out of steam and ended at the upper median line of my Schiff pitchfork.

Step 3: Using the MACD-Histogram for Trade Confirmation

Step 3 is the most crucial part of my entire trade process since I only want to enter after I have had trade confirmation that the conditions are ready to enter a trade.

Look at what happened when price started approaching the upper median line. The MACD-Histogram started diverting from what price was doing, resulting in momentum divergence.

The momentum divergence on my MACD-Histogram, therefore, signalled that I could enter a short position in Crude Oil.

Shortly after my first trade, I was presented with another trade setup when price hit my 1.618% Fib extension level, followed by another correction higher. As soon as price hit my upper median line, so did the MACD-Histogram started showing very slight momentum divergence.

The chart above displays the same correction but this time set to a 30-minute timeframe. Although the momentum divergence on my 4-hour chart was questionable, the 30-minute chart instead showed very strong divergence as price approached my upper median line.

Tip: Using a lower timeframe, like the 30-minute is a great way to confirm momentum divergence if you are unsure about what your larger timeframe might be indicating.

Step 4: Trade Entry and Management

Once my MACD confirmed that the conditions were ripe to enter, I went ahead and placed my sell order at 59.30 with a stop-loss order above my red warning line at 60.80.

I will typically aim for two targets and in this case, I placed my first target at the low of the correction with my second target at the lower red warning line.

Tip: Not only do pitchforks work great at finding the end of corrections, but they ALSO work well to determine where you should place your targets. Just make sure that your pitchfork is sloping into the direction you want to trade. I tend to use a Schiff pitchfork to place my targets because the slope or angle of the median lines are much flatter, meaning that I have a higher probability of reaching my targets.

Conclusion

Indicators are great tools that can assist you in making your own trading decisions, but when used on their own, with no solid trading strategy as a backup can lead to disaster. Following a process, before you trade, like the strategy I have shown , helps to prepare you for an entry ahead of time and a great indicator like the MACD, when used in conjunction with other analytical techniques can greatly improve your accuracy when entering trades.

Momentum divergence can pop up at any moment on a chart but when it shows up at the right places, like median lines, then they become powerful indications that a change in trend is about to occur.

If you would like to test these concepts for yourself, then try to draw pitchforks on your favourite market and watch how the MACD tends to show momentum divergence, time and time again before a reversal happens.

CFD Highlights