MACD Trading – The Divergence Strategy
The MACD indicator was created by Gerald Appel in 1979, and it is one of the most popular technical analysis indicators.
MACD stands for Moving Average Divergence Convergence.
Many new traders use the MACD incorrectly, by applying it to their strategy as a timing indicator of when to enter a position.
However, one of the most effective ways to use it is for divergence.
Let’s look at what it is first, and then jump into how to apply it to your trading strategy.
MACD Trading – How It’s Calculated
The traditional MACD trading values are 26 and 12. The MACD indicator is simply a combination of the 26 and 12 period exponential moving averages.
In addition to applying these two moving averages, a third moving average is used to “smooth out” the price action. Typically the third one is a 9 period exponential moving average.
After applying the moving averages, the MACD indicator also has a histogram which simply shows the difference between the two lines.
The actual formula is a little more complicated than above, but you really don’t need to know it to apply it successfully to your trading strategy.
As you can see below, the image on the top is just exponential moving averages while the bottom one is the MACD. They are very similar in appearance.
MACD Trading – Sorting Out the Common Confusion for Novice Traders
There is a great sense of confusion as to what the MACD indicator is used for.
The reality is that most traders over complicate its existence and apply it incorrectly to their trading strategy.
It is not a stand alone trading system, nor is it the one and only technical analysis tool to follow.
MACD has an amazing use as just one tool in your entire belt.
In the next section I will show you the most powerful practical use.
MACD Trading – The Best Way to Use the MACD Indicator
The MACD is the best divergence indicator around.
What is divergence?
In trading, divergence is when stock prices are increasing but the strength of that price movement is weak.
When stocks are increasing but strength is decreasing (measured by MACD value), this is called “bearish divergence”.
But when stocks are decreasing while strength is increasing (measured by MACD value), this is called “bullish divergence”.
Basically, the direction of the MACD trading indicator is what predicts the future movement of the price. This is why it is said that MACD can “lead” price.
Let’s take a closer look at some examples of both divergences.
MACD Trading – The Bearish Divergence
Apple prices increased from November 2017 to January of 2018.
However, you can see the MACD trading indicator was moving down in that same time period (chart below). This is called a bearish divergence.
But how accurate and helpful was knowing this bearish divergence?
Take a look at the move that followed immediately after.
Apple dropped almost 16% in just 21 days following the bearish divergence.
MACD Trading – The Bullish Divergence
Just to keep things interesting, the next example is of a bullish divergence that is happening at this very moment.
If you look at a chart of Proctor and Gamble (symbol PG) – you will notice that price has been dropping four consecutive weeks.
Looking at the MACD trading indicator however, you can see that strength of price is increasing. This is a classic bullish divergence indication.
What does it mean? It could be time to start looking to buy PG shares (or options).
But once again, the MACD trading indicator is just one tool, and you will need to do other technical analysis before taking a position.
MACD Trading – Conclusion
In this article I shared two of the most powerful ways to use MACD in your trading strategy.
You do not want to make this your primary, go to trading signal.
But it is certainly very useful in a diversified strategy with multiple tools for trading confirmation.
If you want to learn more about how you can create your very own trading strategy, I would love to walk you through the process outlined in our Swing Trading subscription course.
Good luck and good trading.
If you want to join us in our live trading room, check out the Day Trader package here >
If you prefer to trade more passively, checkout our newsletter, trade ideas and live analysis in the Swing Trader package here >
The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.