Traders Blog

Reconsidering MACD divergence for intermediate traders
22/08/2018

Using the moving average convergence divergence (MACD) indicator to trade reversals is among the most popular techniques of shorter-term forex traders and has been for some time. Like any strategy, though, this has its limitations: MACD is often known to give false signals or not provide any signals before price turns.

Before evaluating an indicator, the MACD included, a trader needs to understand roughly how it’s calculated. In this case, MACD is formed of two main components:

  1. MACD histogram = fast exponential moving average (typically 12-period, close) – slow EMA (typically 26-period, close)

  2. Signal line = 9-period simple moving average of histogram

Calculating yourself exactly what MACD displays at a given time is unnecessary (MT4 does this for you), but it is very important to remember that MACD is, as its name implies, based on the space between different moving averages.

This in itself can be overlooked by newer traders, though. If you’re trading with EMAs on the main chart of a symbol, these are giving you the same information as MACD so one of these two is going to be redundant. Even if you have SMAs on the main chart though MACD is also likely to be of limited use because it’s based on essentially the same input, just weighted slightly more toward recent data on price.

MT4's MACD can give false signals

The screencap above highlights the possibility of MACD to give false signals when used by itself. We can see that even though price continues to move up and there is no indication other than from MACD that a reversal might occur, MACD declines slightly. Part of the reason for this is that it’s pretty much inevitable that some divergence will happen after a fairly major, quick movement in price like we often see with crude oil.

Nonetheless, indicators are really only as good as the people using them – the key takeaway from this example is that MACD divergence is unreliable after strong movements. Traders should remember that MACD falling as in the lower yellow circle above can simply indicate lower momentum rather than an outright reversal.

Of course, all of this isn’t to say that MACD isn’t worth using. Quite the opposite, it can be a highly useful indicator, but this assumes that the trader who chooses to employ it can accurately identify its limitations.

Mention should also be made of MACD as originally designed. When the indicator was created by Gerald Appel in the late 70s, he intended for it to give clear buy and sell signals based on the interactions between two separate lines in the indicator.

Traditional MACD's signals are clearer as context for trades

This traditional MACD seen here is similar to MT4’s built-in version but it does display information somewhat differently, having three distinct elements:

  1. MACD line = fast EMA (typically 12-period, close) – slow EMA (typically 26-period, close)

  2. Signal line = 9-period EMA (not SMA) of MACD line

  3. Histogram = MACD line – signal line

While the traditional MACD does often given clearer signals than MT4’s default version, this does not mean that it’s necessarily more reliable when used by itself. In the screencap above, for example, we can see MACD diverging strongly from price from the beginning of May only for the latter to continue its downward movement.

Traditional MACD is available to download for free from MQL5 as are a wide variety of other customised MACDs. You can also try making your own custom MACD. The final word on these and MT4’s MACD though is that like most other indicators they should always have their signals confirmed from other sources before you act on them – MACD divergence in itself doesn’t mean that a trend will reverse.

 

Disclaimer: this article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.

Risk warning: trading CFDs, which are leveraged products, carries a high level of risk and can result in the loss of all of your investment. It’s a good practice never to invest more than you are willing to part with. Before deciding to trade, please ensure you understand all the risks associated with trading CFDs over the counter and take into account your level of experience. Trading forex and CFDs may not be suitable for all investors because these products are difficult to understand. Please seek independent advice if necessary. Past performance of CFDs is not a reliable indicator of future results. Please read our full risk disclosure.

Trade responsibly: CFDs are leveraged products and trading them can result in the loss of all capital invested.
75% of retail traders' accounts lose money when trading CFDs with this provider. Please consider our risk disclosure.
CFDs are leveraged products: all capital invested can be lost. 75% of retail traders lose capital with this provider. View our risk disclosure.