How to Trade the MACD Divergence

How to Trade the MACD Divergence Part 1

Divergence can be one of the more powerful signals in your trading arsenal if used correctly. Today we'll look at the MACD and the divergence signals it produces, and we'll use the most common settings for the MACD which are 26 for the Slow EMA, 12 for the Fast EMA and 9 for the MACD SMA.

Divergence just like the name says, occurs when price and an indicator (in our case the MACD histogram) diverge, either price goes up and the MACD goes down or reverse. There are 2 types of divergence, regular and hidden, the difference being that hidden divergence indicates possible trend continuation while the regular divergence signals a possible reversal of price. Today we'll look at the regular MACD divergence.
On the chart below we can see an excellent example of a MACD divergence on the EUR/USD 1 hour chart that happened very recently on Friday, August 17.

Notice how as the Euro makes a new high the MACD histogram keeps printing new lows. This indicates a possible trend reversal. When you see this divergence happening, you can play it in 2 ways, via an aggressive or a conservative entry. The aggressive entry doesn't wait for the MACD histogram bar to close down to confirm the downward direction of the price but enters right away.
This has its pluses and minuses, the main drawback is the risk. Since the MACD histogram has not yet confirmed the direction down, there is a higher risk of price going up or stalling. The main plus of such entries is the lower risk. Since you will be entering earlier you may get a better price thus keeping the risk lower and the reward higher leading to a better risk to reward ratio, that may compensate for the lower win percentage. However keep in mind that aggressive entries require lot more experience to trade and are not recommended if you're relatively new to trading divergence.
The conservative entry waits for MACD confirmation
Under the conservative entry we would wait for the MACD histogram to head down and thus confirm the signal down. In the chart above notice how at 12:00 the MACD histogram closed higher then the previous bar while price also spiked higher. We get a confirmation for a conservative entry when the MACD closes down at 13:00. The EUR/USD pair closed the 12h bar at 1.2367 but was trading lower at 1.2359 at 13:00, at the time of the conservative entry. In this case, you may have gotten a better price with the aggressive entry although that's debatable because we can't see how the MACD and price behaved between the open and close of the 1h bars. From the conservative entry at 1.2359 the Euro fell 71 pips in the next few hours. Keep in mind your 1h charts may differ from mine depending on what broker you use and their server time.
In the other parts we'll look at that the conditions under which the MACD divergence works best and also look at the situations where it fails miserably. We'll also look at ideas where to put the stop loss and take profit orders. Until then experiment with spotting the MACD divergence on your charts and maybe test it out on a demo account.

How to Trade the MACD Divergence Part 2

When to Trade MACD Divergence + Stop Loss and Take Profit Levels

Last time we talked about how to spot a MACD divergence and we looked at the different types of divergence, regular and hidden. See Part 1 HERE. Today we'll go over regular divergence in more depth, explaining where to put the stop loss and take profit orders and toward the end we'll go over the conditions under which this type of divergence performs best.
Since the regular divergence is a trading setup that aims to pick tops and bottoms to some extent, setting the stop loss is fairly straightforward. See the chart below for an example of a MACD divergence spotted on Friday, August 17 2012.

The stop loss in this case would go just above the swing high, which was at 1.2381. The entry was a conservative one, meaning we waited for the MACD histogram to close down to confirm the sell signal. Entry at the hourly close was at 1.2359. Setting the take profit can be little tricky, you could use a previous support or resistance level, a moving average or a just use the same distance as the stop loss level as take profit, in our case 23 pips. This is called 1R, meaning your take profit is the same as 1 Risk (risk=stop loss). On the chart above we can see that price not only reached our Take Profit = 1R level but continued to fall, in fact the EUR/USD pair lost 71 pips in few hours, marking a swing low of 1.2288 before recovering.
Setting take profit at 1R is simple but it may not be the best course of option since it does look a bit arbitrary, so it's important to experiment with different ways to take profit.
Regular MACD divergence excels in a ranging environment
Now let's look in what conditions does regular MACD divergence work best. Last few days we got a perfect string of divergence signals. See chart below.

The EUR/USD pair was ranging in a 140-150 pips range and delivered 4 nice looking divergences. If we used 1R as our take profit level, we would have gotten 3 Wins and 1 Loss. The first signal was a loss mainly because the conservative entry got us in too late in this case, so even though price rallied 70 pips from our entry it wasn't enough to reach out TP, as our stop loss was set at 74 pips in this case. This example shows the arbitrary nature of using 1R as take profit level so it's good to remember to experiment with this. But even with a simple TP of 1R regular MACD divergence excelled in a ranging environment.
Now lets look at some trending periods. Being mainly a counter-trend or top/bottom picking trading signal, the regular MACD divergence performs poorly in a trending environment. See the chart below for an example of this.

During trends price can deliver several regular MACD divergence losses in a row. Price can make a new divergence as it makes a new bottom, but after we enter it stops us out with another new bottom and a new divergence. In the chart above, if we use 1R as our take profit level, we get 2 Wins and 3 Losses in this type of market.
In conclusion, the regular MACD divergence works best in a ranging environment, so try and identify ranges and stay out of the way of trends to put the odds in your favor. Good luck in your trading.