Don't Trade Based on MACD Divergence Until You Read This

MACD divergence is a popular tool, yet highly inaccurate. Learn the pitfalls.

The MACD--moving average convergence divergence--indicator is popular among traders and analysts, yet few really understand it. Divergence on the MACD is one of the ways the indicator is used, and takes two forms. When the price of an asset is moving one direction and the MACD in the other, that's divergence. This type of signal is supposed to warn of a reversal, but as discussed below, the signal is random and often inaccurate. 

Another type of divergence is when the price makes a new high (or new low) but the MACD doesn't. Traditionally this indicates the price is losing momentum and prime pickings for a reversal. This also tends to be a very poor trading signal.

By understanding the MACD a little more, you'll understand how it actually works so you don't get fooled by its common false signals or lack of signals (when the price turns but the MACD doesn't provide warning).

Problems With Divergence After a Sharp Move

The MACD moving in the opposite direction as price isn't always a warning sign.

Without going into the math of the indicator, monitoring the MACD in relation to price action reveals a few problems which could affect the MACD-divergence trader. 

Note: If trading with a technical indicator, any indicator, be aware of exactly how it functions, so you know all of its drawbacks and benefits.

Divergence will almost always occur right after a sharp price move higher (or lower). Determining whether a price move is sharp (or slow, or large or small) requires looking at the velocity and magnitude of the price moves around it. The price momentum can't continue forever so as soon as the price begins to level off, the MACD will diverge (for example, go up, even if the price is still dropping).

After a strong price rally MACD divergence isn't 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 attached chart (click here for larger version) the EURUSD 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)

Divergence on the MACD can be deceiving.

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--a traditional warning signal of a reversal

This is also fallible, and related to the problem discussed above. A lower MACD high 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 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 can march 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 an indicator which isn't useful in this situation (see: Probabilities in Trading).

The attached chart (click here for larger version) 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. This 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 indicator on day trading chart

MACD divergence seems like a good tool for spotting reversals. Yet it is highly inaccurate, untimely, produces many false signals and fails to signal many actual reversals. 

Traders are better off focusing on the price action, instead of divergence. In order 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.

Final Word on MACD Divergence

MACD divergence--on its own--doesn't signal a reversal in price, at least not with the precision required for day trading. This doesn't mean the indicator can't be used. Just be aware of the pitfalls, and don't use the indicator in isolation. Focus more on price action and trends instead of MACD divergence.