Trading is all about anticipation of price movements. Often, it is about anticipating trend or momentum reversals. Even trend following strategies have some sort of trend reversal incorporated in its strategy but on a smaller scale. Traders who could anticipate trend reversals, whether short-term or long-term, usually have an upper hand compared to traders who have no idea how to anticipate reversals.
There are many ways to anticipate trend reversals. Some traders use price action and price patterns. Others use technical indicators to anticipate a trend reversal. One less popular way to anticipate trend reversals is by looking at divergences.
Price action and trends could be anticipated based on its swing points. Price charts with a constantly rising swing high and swing low is on an uptrend and would more likely create higher highs and lows. On the other hand, price charts with falling swing highs and lows is on a downtrend and is more likely to create lower highs and lows.
Oscillating indicators mimic the movement of price action. Oscillators usually create peaks and troughs in conjunction with the swing highs and lows on the price chart. Most of the time, these peaks and troughs mimic the levels created on the price chart. Higher swing highs and lows usually create higher peaks and troughs. Lower swing highs and lows usually create deeper peaks and troughs.
Divergences occur whenever an oscillating indicator differs from the price action. For example, price might be constantly creating higher swing highs and lows, but on the oscillating indicator, the peaks and troughs are starting to reverse. Although, the trend is still in place on the price chart, there is a good chance that price might reverse soon since the indicator is showing signs of reversal.
There are several patterns of divergences – either regular or hidden. Below are the different patterns that divergences could form.
MACD Divergence v1.1
MACD Divergence v1.1 is exactly what its name implies. It is based on the Moving Average Convergence and Divergence (MACD) and has a mechanism in which divergences could be mathematically identified and plotted on the chart.
The MACD is a basic oscillating indicator which is widely used among many traders. It is computed by solving for the difference between a fast moving average and a slow moving average. The result is then plotted as a histogram or a line. Positive MACDs indicate a bullish trend while negative MACDs indicate a bearish trend. A secondary line, called a Signal Line, is then derived from the MACD line. The Signal Line is basically a moving average of the MACD line. Since the Signal Line is derived from the MACD line, it often lags behind the MACD line. Crossovers between the MACD line and the Signal Line are considered as indications of a trend reversal.
The MACD Divergence v1.1 indicator has both the MACD line and the signal line. In this setup, the MACD line is magenta while the Signal Line is blue.
It also creates lines connecting the peaks and troughs on the MACD line and Signal Line, as well as the corresponding swing highs and swing lows on the price chart, indicating a divergence. Dotted lines indicate a Hidden Divergence while solid lines indicate a Regular Divergence.
Trading Strategy
This strategy is a simple divergence strategy using the MACD Divergence v1.1 indicator.
Trades are filtered based on the trend direction as indicated by the 200-period Exponential Moving Average (EMA) line. Trend direction will be judged based on the location of price in relation to the 200 EMA line. On top of that, the 200 EMA line should be sloping indicating that a long-term trend is in place.
Trade entries are based on the divergence and crossover signals coming from the MACD Divergence v1.1 indicator.
If you would observe a MACD indicator, the MACD and Signal Line usually tend to comeback to the midline often. The farther it is from the midline, the more likely it is to reverse.
This trading strategy initiates trades coming from reversal signals on the MACD Divergence v1.1 indicator. As such, we would be taking trade signals that are on the opposite side of the trend based on the MACD, compared to the trend on the price chart.
Indicators:
- MACD_Divergence_V1.1 (default setting)
- 200 EMA
Preferred Time Frame: 15-minute, 30-minute, 1-hour and 4-hour charts
Currency Pairs: major and minor pairs
Trading Session: Tokyo, London and New York sessions
Buy Trade Setup
Entry
- Price should be above the 200 EMA line.
- The 200 EMA line should be sloping up.
- Both the MACD Line and the Signal Line should be below zero.
- A bullish divergence should be indicated by the MACD Divergence v1.1 indicator.
- The MACD Line should cross above the Signal Line.
- Enter a buy order on the confirmation of the conditions above.
Stop Loss
- Set the stop loss on the fractal below the entry candle.
Exit
- Close the trade as soon as the MACD Line crosses below the Signal Line.
- Close the trade as soon as a bearish divergence is indicated by the MACD Divergence v1.1 indicator.
Sell Trade Setup
Entry
- Price should be below the 200 EMA line.
- The 200 EMA line should be sloping down.
- Both the MACD Line and the Signal Line should be above zero.
- A bearish divergence should be indicated by the MACD Divergence v1.1 indicator.
- The MACD Line should cross below the Signal Line.
- Enter a sell order on the confirmation of the conditions above.
Stop Loss
- Set the stop loss on the fractal above the entry candle.
Exit
- Close the trade as soon as the MACD Line crosses above the Signal Line.
- Close the trade as soon as a bullish divergence is indicated by the MACD Divergence v1.1 indicator.
Conclusion
This trading strategy is a high probability trading strategy. Trading on divergences aligned with the 200 EMA usually produces winning trades.
However, not all trades would produce high yields. Some would yield a decent 3:1 reward risk ratio while others will have returns lower than 1:1.
Some risk-taking traders who have found a way to keep their win ratio above 60% or have at least one win out of every three trades have gone as far as using Martingale strategies with this. However, this should be avoided by prudent traders. A series of losing trades could greatly affect your trading account. Even if the initial trading volume is kept at a minimum, losses could pile up putting traders in a big hole. Instead, a sound trade management and money management strategy should be kept in place using this strategy.
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