What is Moving Average Convergence Divergence?
MACD divergence is a must-have method of technical analysis for binary options traders. It is based on an observation that trends start getting exhausted at some point, even though the price action continues in the previous direction. Several technical indicators measure the momentum or strength of price trends. A period when a trend is losing its power can be determined by the technical analysis, which points to a possible reversal or deep retracement at least. Binary options traders can take advantage of the analysis by getting ready to such reversals, exit from profitable trading cycles and start buying options in the opposite direction in time. This approach uses leading factors capable to drive a counter-trend action. These factors are called divergences.
Besides widely used to confirm trend’s momentum in trend-trading strategies, this powerful technique is also applied to identify divergence which signals reliable reversals. This MACD usage is called Divergence MACD.
Divergences happen rather often in the financial markets as most of the assets are driven by the psychological impact of market players. Since the price of a security is mostly a reflection of expectations based on fundamental events and forecasts, the supply/demand ratio might have significant shifts compared to average weighted prices noted in certain periods. Those shifts create disbalance between the bulls and bears, causing too sharp swings in the cost of assets. However, such powerful technical indicators as MACD can spot the disbalance, indicate the moment when the momentum weakens and the trend is losing its previous strength. This article is aimed to explain the MACD divergence basics, helpt binary options to learn how to spot a divergence and take advantage of it in daily trading.
What is the MACD Indicator?
The MACD indicator is a multi-functional technical instrument measuring trend’s momentum, pointing to the direction of a price change and showing potential reversals. It consists of three components with an effective combination of mathematical formulas. The full name of the instrument is Moving Average of Convergence and Divergence. The main idea is based on several smoothing layers of sharp price swings to assess the current trend from several points of view.
The MACD trend indicator looks like this:
How to read MACD indicator?
MACD has three values and three settings for each of them. The histogram measures the trend’s momentum and shows the dominance of the bulls or the bears. If the histogram changes its position in relation to the zero lines, then the trading conditions would be changed. Two other parts are lines in the indicator’s window: MACD and Signal line. The crossover of those lines usually points to a change in the technical sentiment as well.
A divergence occurs when a trend keeps moving prices in the previous direction, while MACD indicates weakening momentum. In other words, the trend does not have the same power as before, prices print lower gains or losses compared to the previous period and the opposite action becomes more likely. For example, if an uptrend was keeping the sequence of higher highs, but MACD lines were drawing lower peaks, then the divergence would indicate that something is wrong with the current trend.
The mathematical background of the divergence is hidden in several formulas. The basic idea is to compare the change in values of exponential moving averages with different periods and apply an additional smoothing to the difference in peaks and bottoms. As a result, the indicator measures relative gain or loss distributed on the chosen period.
MACD Bullish Divergence
MACD Bullish divergence occurs after a downtrend loses the momentum. The price chart still has lower lows as prices keep declining, while the bears are still in control of the market. However, indicator’s lines chart higher lows in the same period, while their direction is headed towards the zero levels, reflecting the weakening momentum.
Here is an example:
The screenshot shows that NZD/USD was in a long-term downtrend on the daily timeframe. At some point, the downtrend slowed down, the number of consecutive red candlesticks decreased, downside swings narrowed the bearish range. Although the pair continued charting lower lows, pointing to a bearish continuation, MACD lines drew higher lows, causing the bullish divergence. The bullish MACD divergence caused the reversal of the downtrend and a new uptrend began.
MACD Bearish Divergence
MACD Bearish divergence is a mirrored reflection of the previous example. It occurs after a sustainable uptrend when the bulls start losing the momentum. The best way to spot a bearish divergence is to find a period when prices keep charting higher highs, while MACD lines are pointing to lower highs. The period between the peaks has clear signs of a slowdown of the previous uptrend and might lead to a long-term bearish reversal or retracement.
Here is an example:
As the daily chart of shows, the price of gold had a sustainable uptrend. After reaching a certain level, the uptrend started slowing down, the depth of bearish rebound enlarged, prices failed to perform in the same way as before. Although the chart had rising peaks (higher highs), the MACD indicator printed lower highs. The bearish MACD divergence caused a long-term reversal as the price of gold declined to $1460 from $1550 per ounce.
How to use MACD indicator?
First of all, readers may have noticed that MACD divergences are used for long-term analysis. Strong trends usually do not reverse without a reason, and a period of rebalancing has to be in place before the counter-trend action begins. This is why it is important to keep an eye on secondary factors influencing the price action. The fundamental background is crucial for asset prices in terms of trading conditions. If the economic drivers do not support the previous trend any more, the market players would lose the interest to keep moving rates in the same direction as previously.
From a technical analysis point of view, the depth of short-term retracements matters in the scope of the trend’s sustainability. If, for instance, an uptrend had deeper rebounds compared to the past development, then analysts would conclude that the bears are getting more active, even though the price continues edging higher. Another secondary metric to monitor is the MACD histogram. Binary options traders should watch not only lines but also the histogram as if it crosses the level of zero, changing the colour several times, then a change in the technical sentiment is coming.
A technical trigger has to happen before prices start moving in the opposite direction. The most essential trading signal, in this case, is the crossover of MACD lines noted in the indicator’s window. Even if both lines were moving in the opposite direction compared to the price action, but the crossover did not happen, the MACD divergence pattern might indicate just a temporary slowdown of the recent trend but not a reversal. Therefore, the absence of the trigger would not launch the workout of the pattern and the trend would turn to a sideways consolidation.
If you like this strategy, you might also be interested in this Demark Indicator
Finally, the MACD divergence pattern is considered completed when the lines cross the level of zero. In most cases, it happens that they keep moving in the same direction above or below the threshold, and the counter-trend action is in play, however, that movement is related to the market’s inertia and does not necessarily mean further trend. So a divergence is considered as worked off when MACD lines cross the zero line. Here is the full list of conditions to enter the market according to the MACD divergence strategy.
Conditions to buy CALL options on bullish divergence
- The underlying asset has to be in a sustainable downtrend before the pattern occurred;
- If the downtrend continued and the price chart kept printing lower lows, but MACD lines were drawing higher lows, binary options traders should get ready to start buying CALL options. The histogram should not point to a strong bearish momentum;
- The trading signal to start the cycle comes in when MACD lines perform the bullish crossover in the negative territory. The histogram has to turn negative shortly;
- Traders should continue buying CALL options if the price action goes in the correct direction and the sequence of higher highs is in place. The histogram has to be green and rising;
- If MACD lines did not cross the zero level and the histogram turned back positive, then traders should stop buying CALL options;
- If MACD lines performed the bearish crossover in the positive zone, stop the trading cycle.
Conditions to buy PUT options on bearish divergence
- The underlying asset has to be in a sustainable uptrend before the pattern occurred;
- If the uptrend continued and the price chart kept printing higher highs, but MACD lines were drawing lower highs, binary options traders should get ready to start buying PUT options. The histogram should not point to a strong bullish momentum;
- The trading signal to start the cycle comes in when MACD lines perform the bearish crossover in the positive territory. The histogram has to turn positive shortly;
- Traders should continue buying PUT options if the price action goes in the correct direction and the sequence of lower lows is in place. The histogram has to be red and declining;
- If MACD lines did not cross the zero level and the histogram turned back negative, then traders should stop buying CALL options;
- If MACD lines performed the bullish crossover in the negative zone, stop the trading cycle.
Examples of profitable trades
Two examples of profitable trading cycles using MACD indicator are already shown above. Both of them brought a decent profit, even though cycles were short-term. There is also a method based on the technical analysis, aiming to maximize profits from trading binary options, make profitable cycles longer and increase the efficiency of a trading system. The disadvantage of strategies based on a single indicator is that divergences might not lead to sharp counter-trend price action, the weakening momentum comes together with sideways consolidation and the previous trend continues in the same direction. Traders who had entered the market with such a scenario might not get the wished result in terms of several profitable deals in a row, or even face losses related to the false trading signals.
The solution is to add another layer of the analysis thanks to a secondary indicator. Since MACD is a rather slow and lagging indicator, a fast and sensitive instrument could help to improve the efficiency of the trading strategy, increase profits and lower the number of false signals. The Relative Strength Index is one of the most widely used oscillators to combine with MACD to highlight its strength and smooth weaknesses. RSI also has bullish and bearish divergences aimed to confirm the signal coming from MACD or shift the start of a trading cycle to a perfect moment when prices start moving in the right direction.
Here are several examples of how to combine MACD indicator with RSI oscillator in binary options trading;
Buying CALL options after RSI confirmed the bullish divergence on MACD
MACD was with the hourly chart of EUR/USD for quite a while, and even several buy-signals occurred, but the reversal did not happen. Once RSI confirmed the divergence and triggered the beginning of a sharp upswing, the trading cycle started, bringing several profitable deals in a row. The combination of MACD and RSI indicators helped also to spot an opposite signal to exit the trading cycle when MACD lines performed the bearish crossover, while RSI went out of the overbought territory.
RSI helped to spot a perfect entry to start buying PUT options after bearish divergence on MACD
The daily chart below shows the EUR/JPY in a long-term uptrend. Prices kept edging higher at some point, but MACD lines started declining. The bearish divergence had three peaks, while the RSI oscillator highlighted a perfect entry point after charting a bounce with the lower-highs sequence.
MACD indicator is a strong tool to identify periods when the previous trend is getting exhausted and a reversal price action might happen. The trading strategy has a clear set of rules and conditions to enter and exit the market. Although the pattern is quite rare and it requires a long-term analysis, trading signals are effective and profitable. However, the MACD indicator is quite a lagging instrument and some market conditions require an additional confirmation from secondary technical indicators such as fast oscillators. The combination of MACD and RSI is supposed to increase the efficiency of a trading system and maximize profits in binary options trading.