To spot divergences one looks at the MACD lines and the price line. Out of the three signals we have discussed, a crossover of the MACD and signal lines, zero line crossovers and divergence, this last one can be considered the strongest signal.
- Negative or Bearish Divergence - It is usually a signal of a market top when price makes new highs, while the MACD indicator does not match its previous highs. The chance that there will be a market top is even greater if MACD is well above the zero line or shows an overbought tendency.
- Positive or Bullish Divergence - A positive divergence occurs in reverse. The MACD indicator is well below the zero line and begins making new highs, and at the same time price continues declining.
This is usually an early signal of a market bottom.
EUR/USD - Daily Chart - May 2005 to November 2005
Figure 7, the EUR/USD pair exhibit both a positive and negative divergence in the period from June to October of ‘05.
- In the middle of June, the MACD line (in blue) starts to inch upward while the price of the Euro continues its downward trend and keeps declining. This is a positive divergence. After a positive divergence, there is a good chance that the currency is due for a reversal and here an upward movement. In the months of July and August the price succumbs to the buying pressure and rises.
- The negative divergence works in a similar way to a positive one, with everything happening in reverse. Price reaches a higher peak in the beginning of September, but the MACD line does not reach a higher high. This classic symbol of divergence means a reversal of the uptrend may be looming. The price chart shows how the price falls almost immediately after the MACD line fails to reach a new high.
The trader in this example would have to have a long term mentality since the trades come on a daily graph and the divergences come almost three months apart. If one bought the Euro (1.1900) in early June after seeing the positive divergence, and sold Euro (1.2500) in early September, the position changed near 600 pips. The divergence signals, in this example, were very good in predicting both the entry and the exit points. Divergences can happen on shorter timeframes, but one may want to adjust the periods used in the indicator.
