Why MACD divergence may be an unreliable signal

MACD divergence is discussed in most trading books and is often cited as a reason for a trend reversal, or a possible reason for a trend reversal. In hindsight, the divergence looks great; many examples can be found in which a reversal occurred before the MACD divergence.

But if you look closely, you will find a lot of negatives no Before divergence, and usually divergence does not result in a reversal at all. Therefore, before assuming that divergence is a reliable tool to use in your trading, let us understand what MACD divergence is, what causes the divergence, and how to improve the use of divergence.

Key points

  • MACD is a popular technical indicator used by traders in many different markets, but its usefulness has been questioned.
  • One of the main problems with divergence is that it can usually signal a possible reversal, but it does not actually happen—it may produce false alarms.
  • Another problem is that divergence does not predict all reversals. In other words, it can predict too many reversals that have not occurred and not enough actual price reversals.

What is indicator divergence?

Indicator divergence refers to the situation in which oscillators or momentum indicators (such as moving average convergence divergence (MACD) indicators) have not confirmed price changes. For example, stock prices hit new highs, while MACD or relative strength index (RSI) indicators hit new highs.

The SPDR S&P 500 ETF weekly chart shows MACD divergence in an uptrend.

The image above shows an example of divergence during an uptrend. The price continues to rise, but MACD has not made new highs many times, but has created lower highs.

The indicator divergence is intended to indicate that the momentum is weakening during the trend, so it is more prone to reversal. However, as shown in the figure above, divergence is not the right time for a reversal. As early as 2012, there was a divergence on the chart, although the upward trend continued into 2015, and there was a sharp correction in late 2014 and 2015. This is a bearish divergence: when the indicator makes a lower high and the price makes a higher swing high.

A bullish divergence occurs when the price forms a lower swing low and the indicator is at a higher low. It aims to show that the selling momentum is slowing down and that the downward trend is easier to reverse. The chart below shows a bullish divergence; MACD lows are rising, while prices continue to fall. Despite the divergence between mid-2013 and the end of 2015, prices continued to fall.

The SPDR Gold Trust weekly chart shows MACD divergence in a downtrend.

Common problems of MACD divergence

One of the main problems with divergence is that it often sends out (possible) reversal signals, but in fact no reversals occur-this is a false alarm. Another problem is that divergence does not predict all reversals. In other words, it predicts too many reversals that will not happen, while actual price reversals are not enough.

We will describe how to deal with these issues in the next section. First of all, these are two common causes of false alarms—almost always occur in certain situations, but they do not necessarily lead to reversals.

Disagreements always occur when there is strenuous (large exercise in a short period of time) exercise followed by less strenuous exercise. This is actually a departure from what is meant to be captured, because many traders believe that if price movements slow down, there may be a reversal.

The chart below shows a stock gapped higher and then accelerated. This rapid and large price change caused the MACD to jump, and because the price could not continue to maintain a higher gap, there was a divergence. The divergence in this case does not indicate a reversal, but the price change is slower than the price change that caused the indicator to jump (the gap is higher). The gap caused an abnormal jump in the indicator, so as the price returned to a more “normal” behavior, there was a divergence. Each price wave of a trend is different, and not all price waves move quickly in a short period of time. In this case, the price increase slowed down after the price increase, causing the MACD reading to fall, but there was no reversal.

The daily chart of Apple Inc. shows a “false positive” divergence.

After sharp price fluctuations, subsequent price changes are almost always slower (shorter distance covered or shorter time covered), even if the trend may still be valid.

“False positive” divergence also often occurs when prices move sideways, such as moving in a range or triangle pattern following a trend. As mentioned earlier, a slowdown in price (lateral movement or slow trend movement) will cause the MACD to move away from its previous extremum and move towards the zero line.

When prices are trading sideways, MACD tends to the zero line because the distance between the 26-period moving average and the 12-period moving average (as measured by MACD) has narrowed. When the price moves sideways, the moving averages (shown below) are difficult to move away from each other. The signal that MACD may provide may be reduced when this happens, because the moving average-on which the indicator is based-does not work well in volatile or sideways markets. (Moving averages tend to work better in trends.)

AT&T Inc.’s weekly chart shows that the MACD tends to zero during the sideways price movement.

Since MACD almost always tends to zero and may be far away from previous extreme MACD highs or lows, when prices are trading sideways, MACD almost always diverges. Usually, these signals are almost useless, because as the moving average swings back and forth, the MACD just fluctuates around the zero line.

After discussing some of the potential problems of MACD and what to pay attention to, here are some ways to use price action analysis to improve MACD divergence.

Always take advantage of divergent price action

Price is the final indicator, and momentum indicators are just manipulating price data. When using MACD, price action is used to assist decision making.

Here are some basic guidelines for doing this:

  • When price changes slow down (relative to previous price fluctuations) or sideways, MACD is expected to diverge. This is not necessarily a sign of reversal.
  • If there is a divergence, do not withdraw from the current transaction just because of the divergence. For example, if a stock is in an uptrend, don’t exit a long trade just because there is a divergence. As the chart shows, divergence is not a good timing indicator and may not cause a reversal at all.
  • If you want to enter a trade based on a divergence, please wait for the price to break the current trend, confirm the divergence, and then take action. For example, if the trend is up but there is a bearish divergence, then go short only when the price breaks the uptrend and enters the downtrend. In an uptrend, the price must form a lower swing high and a lower swing low to indicate a new downtrend. To reverse the downward trend, the price must form a higher swing high and a higher swing low.
  • There is more trust in price behavior than disagreement. If the price breaks through the previous trend, even if there is no divergence in the reversal, pay attention to the warning.

Even with these guidelines, deviations may provide useful insights for some transactions, but not for others. This is a tool that may help trading but is not perfect. We need to understand the weaknesses and help make up for them by analyzing price behavior.

Bottom line

Using indicators or deviations is not a bad thing. Divergence indicates that prices are losing momentum relative to previous price fluctuations, but it does not necessarily indicate a price reversal. There is no need for disagreements when the trend is reversed. When prices move sharply in the direction of the trend and then move sideways or continue the trend but at a slower rate, divergence almost always occurs. Consolidation after a sharp rise is usually a sign of trend strength, not a reversal implied by a MACD divergence.

When using divergence, please understand the cause of the divergence, so that you can avoid some of the problems of indicator deviation. Analyze price behavior; without the use of indicators, a trend slowdown is obvious, as is a price reversal. If you use divergence, test its effectiveness in helping you enter and exit points within a few months to assess whether the divergence improves your performance.

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