Don't Trade Based on MACD Divergence Until You Read This
MACD divergence is a popular tool, yet highly inaccurate. Learn the pitfalls.
The moving average convergence divergence (MACD) indicator is popular among traders and analysts, yet there's more to using and understanding it than meets the eye. The MACD indicator uses moving-average lines to illustrate changes in price patterns.
When the price of an asset, such as a stock or currency pair, is moving in one direction and the MACD's indicator line is moving in the other, that's divergence. This type of signal is supposed to warn of a price- direction reversal, but the signal can be misleading and inaccurate.
Another type of divergence is when a security's price reaches a new high (or a new low) level, but the MACD indicator doesn't. Traditionally, this would indicate that the price's direction is losing momentum and is priming for a reversal. This can also prove to be an unreliable trading signal.
While you don't need to understand the math that underlies the calculation of the MACD trendlines, by understanding more about how the MACD indicator works, you'll be better positioned to avoid getting fooled by its false signals or lack of signals, such as when the price turns but the MACD doesn't provide any warning.
Issues With Divergence After a Sharp Move
Monitoring the MACD technical indicator in relation to price action reveals a few problems which could affect traders who rely on the MACD divergence tool.
A divergence pattern between the two MACD trend lines will almost always occur right after a sharp price move, whether higher or lower. Determining whether a price move is sharp, slow, large or small requires looking at the velocity and magnitude of the price moves around it.
Price momentum can't continue forever so as soon as the price begins to level off, the MACD trend lines will diverge (for example, go up, even if the price is still dropping).
After a strong price rally, the MACD divergence is no longer useful. By dropping, while the price continues to move higher or move sideways, the MACD is showing momentum has slowed but it doesn't indicate a reversal.
In the pictured chart, the EUR/USD is falling, yet the MACD is rising. Had a trader assumed that the rising MACD was a positive sign, they may have exited their short trade, missing out on additional profit. Or they may have taken a long trade, even though the price action showed a significant downtrend and no signs of a reversal (no higher swing highs or higher swing lows to indicate an end to the downtrend).
That doesn't mean divergence can't or won't signal the occasional reversal, but it must be taken with a grain of salt after a big move.
Since divergence occurs after almost every big move, and most big moves aren't immediately reversed right after, if you assume that divergence, in this case, means a reversal is coming, you could get yourself into a lot of losing trades.
Problems with Divergence Between MACD Highs (or Lows)
Traders also compare prior highs on the MACD with current highs or prior lows with current lows. For example, if the price moves above a prior high, traders will watch for the MACD to also move above its prior high. If it doesn't, that's a divergence or a traditional warning signal of a reversal.
This signal is fallible and related to the problem discussed above. A lower MACD high-price level simply shows the price didn't have the same velocity it had last time it moved higher (it may have moved less, or it may have moved slower), but that doesn't necessarily indicate a reversal.
As discussed above, a sharp price move will cause a large move in the MACD, larger than what is caused by slower price moves.
An asset's price can move higher or lower, slowly, for very long periods of time. If this occurs after a steeper move (more distance covered in less time), then the MACD will show divergence for much of the time the price is slowly (relative to the prior sharp move) marching higher.
If a trader assumes a lower MACD high means the price will reverse, a valuable opportunity may be missed to stay long and collect more profit from the slow(er) march higher.
Or worse, the trader may take a short position into a strong uptrend, with little evidence to support the trade except for an indicator which isn't useful in this situation.
The chart pictured above shows a downtrend in APPL stock. The downtrend is caused by sharp downward moves, followed by slower downward moves. The sharp price moves always cause much bigger downdrafts in the MACD than slower price moves.
It results in divergence when the next price wave isn't as sharp, but in no way indicates a reversal. MACD divergence was present this whole day, yet the price dropped all day. If monitoring divergence, an entire of day of profits on the downside would have been missed.
Another problem with watching for this type of divergence is that it often isn't present when an actual price reversal occurs. Therefore, we have an indicator which provides many false signals (divergence occurs, but price doesn't reverse), but also fails to provide signals on many actual price reversals (price reverses when there is no divergence).
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The Trend and Price Action Matter More
MACD divergence seems like a good tool for spotting reversals. Its inaccurate, untimely information produces many false signals and fails to signal many actual reversals.
Traders are better off focusing on the price action, instead of divergence. For a downtrend to reverse, the price must make a higher swing high and/or a higher swing low.
To reverse an uptrend, the price must make a lower swing high and/or a lower swing low. Until these occur, a price reversal isn't present. Whether divergence is present or not isn't important. Traders make money off price movements, not MACD movements.