Big MAC Divergence in Better Trades

Indicators are a powerful tools and they generally have a very specific function. They measure specific aspects of behavior and that behavior is compared to the chart movement. Some indicators are very narrow in focus i.e. only relavent in trends or only in compression patterns while other indicators work well in nearly any market patterns. Some of the more common and respected indicators measure over bought / oversold conditions or trend strength or divergence. I will focus this article on the divergence indicators and how to recognize divergence.

There are several indicators that can be used for divergence. They vary in their accuracy as some measure divergence as their primary function and others as a secondary function. The most recognized divergence indicator is Gerald Appel's Moving Average Convergence Divergence (MACD). This indicator compares moving averages to each other and gives Bullish and Bearish signals but it's real unique quality is to predict major changes in direction by revealing discrepancies in it's pattern with the chart's pattern before the change. MACD is well respected and the general adage is that MACD will have a significant discrepancy with the stock chart 2-3 times per year.

MACD may be displayed both as a two line indicator and a Histogram.

While the data is the same, the Histogram is not the form that gives the major divergence signals. In fact the use of the histogram is somewhat controversial.

Construed by Thomas Aspray, it attempts to anticipate the cross over of the faster (green) and slower (red) lines which gives a bullish and or bearish signal. This is a secondary talent for MACD so for the discussion of divergence, we will focus on the original two line version. In looking for divergence, the two lines are looked upon as one. The two line chart is formed by entering 3 time frames to the moving average formulas. The classic data points are 12, 27 and 9. For shorter term trading I use a shorter time frame setting of 8, 18 and 6. There is also a Zero / Center line for reference.

MACD can predict changes but the time frame can vary dramatically. The predicted change can show up one week or many weeks later. The prediction is usually right but not necessarily right away. The actual change usually happens at a support or resistance line. Early divergence should have you looking closely at your chart for your key pivot points.

Divergence is the measurement of discrepancy. When two things are measured and compared to each other, they are either moving the same way or diverging. MACD stands for convergence and divergence. That means that the pattern of the indicator may be moving toward the stock (convergence) or away from it (divergence). This can be confusing and assumes that the stock chart is on top of the indicator chart.

While you can learn to understand and read MACD this way there is something that can make it easier to learn and interpret.

Simplify terms (lose the convergence)

The normal way to display MACD is to place it in a separate window below the chart window. The confusion I mentioned comes from directional terms assigned to MACD. Converging (coming toward) and diverging (moving away) are only relevant because of the position of the two windows. For example, if you placed the indicator window on top of the chart window, convergence and divergence would switch roles.

I prefer to relate divergence to the core issue, bullish or bearish divergence. The distinction of convergence and divergence are unnecessary. Divergence is discrepancy. If you are moving the same direction as the stock you are in sync with it, agreeing with it. If you are not, you are diverging. It does not matter if you are moving toward or away, you are diverging. That divergence will either have a bullish or bearish warning.

I teach my students to use the terms "Bullish and Bearish Divergence". Convergence is done away with altogether. If MACD is moving down while the stock is moving up, it is Bearish Divergence. A rising indicator against a falling stock is Bullish Divergence.

Divergence is not too tough to see but it takes time to get comfortable with it. Keep in mind that the settings control how far back you can look for relevance. The 12, 27, 9 settings will let you compare more time than 8, 18, 6. In other words you can not look at a peak in February and compare it's height to a peak 6 months earlier. There is no 0 to 100 scale. The Zero / Center line allows MACD to reset. You can only use about 2 -3 months of time when using the shorter settings and 3-4 months with the longer settings.

But you can compare the neighboring few months to any spot you pick as a starting point. This is very helpful in learning from history. You can practice identifying divergence by using the historical data. At any point you can look 2-3 months either forward or back.

Divergence in MACD is a real gem. At 2 - 3 times per year it is a great consultant and forecaster of trend change. As with any indicator, it is best to have a few opinions and look for multiple confirmations. Support and resistance lines will generally correlate with the reversal signals predicted by MACD. While there is still much more to learn about MACD , Divergence is the first and most valuable characteristic.

Interested in learning more? I invite you to sign up to attend one of my free trading webshops.

Ryan Litchfield with BetterTrades

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