Divergence with Price
Forex Trading Floors “How to Trade” blog this week’s Divergence with Price follows on from last weeks “How to Trade Using MACD.
When price diverges from the MACD, it signals the end of the current trend. When the price is rising and MACD is falling (negative divergence), or vice versa, it can be considered an indication of something going on and can be used to predict changes in a trend. That’s right, the lagging indicator that is supposed to follow the price is predicting future behaviour.
MACD divergence with price means that the current price trend is running out of steam. In theis case, you would create trade plans based on reversal patterns, moving average crossovers or other indications to consider a trade in the opposite direction. It may not happen right away but MACD divergence with price can be a powerful hint that the market is changing.
What you are looking for is when price action and MACD do not agree. For example if price is making a series of higher highs and MACD is making a series of lower highs, something between the two is out of sync and you have divergence with price.
Divergence can also be found with the Histogram.
There are two powerful keys in locating possible times where divergence is likely to represent a reversal in price:
1. Support and Resistance: When planning a trade around a bounce or break of S&R, MACD divergence indicates that current price action is running out of steam, there are not enough committed traders to break S&R so a rejection reversal would be most likely. MACD divergence with price can be very powerful when price is at double tops or double bottoms.
2. Exhaustion Pullback: When an oscillator, an overbought/oversold indicator has reached its overbought/oversold range and is turning back down to normal.
Note: You may often see the MACD lines extremely overbought of oversold, this is not a reason to trade in fact it indicates signs of strength. It’s overbought/oversold because everyone is buying/selling. When price reaches its extreme, where it’s gone too far, too fast, you will see price exhaust and the MACD lines drop back into the normal zone giving a better signal.
Combining an exhaustion MACD pullback with MACD divergence at a double top, you would have a second cross of the MACD and an opportunity to trade.
Next week on “How to Trade” Forex Trading Floors will cover “Dramatic Expansion.
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