Are You Trading MACD Divergence Correctly?
One of the most powerful technical indicators that you can use in any market is the MACD oscillator, invented by Gerald Appel in 1979. The MACD, which is short for moving average convergence divergence, is one of the most popular lagging indicators among traders as well.
Many traders use this indicator to trade divergence between the indicator and price, which can be a powerful trading technique if done correctly. Are you trading MACD divergence correctly? In this article, I’m going to show you how to trade MACD divergence like the pros.
Are You Trading MACD Divergence Correctly?
For starters, you should determine whether or not you are using the best MACD indicator for the job. For instance, the default MACD indicator in MetaTrader 4 does not use the original MACD formula and is completely useless when it comes to trading traditional histogram divergence.
I’ve also seen MACD indicators, in other trading platforms, that only display the histogram, leaving out the MACD and signal lines. In order to trade MACD divergence the way I’m going to teach you, you need to use a true, traditional MACD oscillator.
The image above is an example of a traditional MACD oscillator. You can see the histogram (bar graph) in gray, the MACD line in blue, and the signal line in red. Of course, the colors can vary between platforms and indicators, or due to user settings.
The MACD line is the fast line. The signal line is the slow line (average of the MACD line). The histogram shows divergence between the MACD line and signal line.
What is MACD Divergence?
The typical definition of MACD divergence is when price and the MACD indicator are going in separate directions. As a trading method, at least in our case, we’re not talking about the divergence between the MACD line and the signal line.
MACD divergence is, for example, when price is making lower lows while the histogram or MACD line is making higher lows or double bottoms. The idea is that the slowing momentum displayed by the indicator could be an early sign of a reversal.
In the example I mentioned, we would have bullish divergence. We would have bearish divergence if price were making higher highs while the histogram or MACD line was making lower highs or double tops. Similarly, price could make a double top while the histogram or MACD line made lower highs.
In the image above, I marked the bullish divergence in green and the bearish divergence in red. Notice that I marked divergence when price was either down trending or up trending. I completely ignored the range bound period.
There are a couple of shortcomings to trading MACD divergence, and trading from a ranging market is one of them. During a ranging market, the MACD and signal line will cross the zero line frequently. You should avoid trading divergence, and possibly trading altogether, during these periods.
Note: It’s also important to trade MACD divergence from distinguishable higher highs or lower lows in price. For instance, the bearish divergence (red) in the image above barely qualifies, because there were such small retracements in price during that uptrend.
Keys to Trading MACD Divergence Correctly
When traders first realize how powerful trading MACD divergence can be, they often make the mistake of trying to trade the MACD on its own. I don’t recommend this because the MACD can give many false positives on its own.
Instead, I recommend using MACD divergence strategies with other trading strategies – preferably ones that use leading indicators, like price action or support and resistance. The right combination of lagging and leading indicators can provide you with a real edge in the market.
In the image below, I marked the bullish divergence (green), the bearish divergence (red), and an example of bad divergence (gray). I also marked some entry signals. For the purpose of this article, we will be using price action signals in conjunction with the different forms of MACD divergence.
Starting from the left, you can see some traditional MACD histogram divergence. The histogram is making higher lows or double bottoms, while price is making lower lows. If we were using price action as our confirming entry signal, we would have skipped the first two examples of bullish divergence, because there were no bullish candlestick signals to confirm our entry.
The next two examples show both histogram and MACD line divergence. They also both developed bullish engulfing signals which could be used to confirm entry at each of those divergence points (click the image for a better view).
Note: Oddly enough, according to the way I trade candlestick patterns, I would have made a full take profit (2:1) after the first bullish engulfing pattern. I would have been stopped out at break even, if I had taken the second bullish engulfing pattern. At first glance, you would think it should be the other way around.
Next, we have an example of bearish divergence. A strong candlestick signal, the bearish engulfing pattern, developed at this point as well, confirming its significance. During this period, the divergence occurred between price and the histogram.
Divergence also occurred between price and the MACD line. You’ll notice that the MACD line only made a small kink (or micro divergence). Micro divergence can occur when price is making smaller retracements, or during periods of high volatility. Either way, micro divergence can be a very significant signal in the right situation.
After that, I marked a bad example of divergence. The reason this doesn’t qualify as a good example of divergence is because the retracement that made the first low was so small that it’s barely noticeable. Remember what I said about distinguishable higher highs or lower lows in price being important?
Price action through this area is too smooth. There was not enough up and down movement in price to establish any distinguishable lows. Compare this period to the downtrend on the left of the image. There you can see very distinguishable lower lows in price. The lows on the histogram were also very distinguishable, which is helpful but not critical.
Next, we have another example of bullish histogram divergence. This bullish divergence also coincided with a possible bullish candlestick signal, a bullish engulfing pattern. However, the real bodies of the candlesticks are relatively small compared to the other candles in the area. For that reason, I would have skipped this trade, although it would have worked out.
Finally, we have another example of bullish divergence that occurred between price and both the histogram and MACD line. In this case, there was no candlestick signal to confirm a trade, so we would have stayed out of the market.
Hopefully, you can see from the examples that I’ve given that learning how to trade divergence between the MACD and price can be a very powerful tool in your arsenal. Trading MACD divergence in combination with almost any other type of trading strategy can increase that strategy’s profitability exponentially.
Trading MACD divergence, if done correctly, can provide you with a real edge in the market. It can be a powerful early indicator of trend reversals when combined with another trading system – preferably a system based on leading indicators.
MACD divergence isn’t foolproof. This technique does not work well in range bound markets, and on its own MACD divergence will often give you many false positives. This is especially true when the market is trending strongly in one direction for an extended period of time.
It is important to only trade divergence signals that occur during periods of distinguishable higher highs or lower lows in price. Strong, parabolic moves in price, in one direction or another, with little to no retracement, do not make good divergence signals.
Are you trading MACD divergence correctly? Hopefully, this article shed some light on any mistakes you might be making with this popular trading technique. Like anything else in trading, you can’t expect to be an expert divergence trader overnight. Be sure to do plenty of backtesting and demo trading before trying any new trading strategy in your live account.
The employment rate is a number of people who have jobs expressed as a percentage of the total workforce. It is the third important indicator for foreign currency markets. Like GDP, the employment rate of population capable of working mirrors an economic environment of a country and its health. Every country sets its threshold of the unemployment rate. Therefore, it is faulty to compare the same unemployment indicators of any two counties. So, economists are focused on a more important aspect, to be exact, how employment statistics change in the course of time in a particular country. Let’s consider, for example, the United States. Nonfarm payroll (NFP) is an indicator which is a driving force of the market. As a rule, it makes a strong impact on trading. Monitoring of exchange rates proves that the forex market reveals short-term changes before and after a nonfarm payroll publication. Therefore, this indicator is high priority when analyzing the forex market. Let’s get an insight into this employment indicator. A nonfarm payroll is reported monthly by the US Bureau of Labor Statistics. The data is released on the first Friday of the month at 8:30 EST. What does nonfarm payroll mean? This indicator represents a total number of paid US workers of any business excluding the following employees: - Farm employees; - Private household employees; - Employees of nonprofit organizations; - Government employees. The indicator accounts for approximately 80% of employed American nationals. It is used by the US Federal Reserve and government policy makers to judge the current and future state of the economy. Resting on the nonfarm payroll, officials determine both domestic and foreign monetary policy. Importance of nonfarm payroll The nonfarm payroll shows how many jobs appear on the US labor market. When more vacancies are added, it means that newly employed people have money to spend on goods and services. Therefore, higher spending bolsters economic growth. For this reason, the nonfarm payroll is considered to be the key leading economic indicator. As a rule, US GDP growth makes a positive impact on the US dollar exchange rate against other global currencies. Besides, the boosting American economy could affect other economies in a benign way. As a result, recovery will trigger an interest rates hike in the US. All these factors make the US dollar more beneficial on the global market. It means the greenback will go on reinforcing against other global currencies. How NFP influences trading on Forex The nonfarm payroll statistics is used in fundamental analysis. A scale of the report’s impact on Forex has a direct correlation between actual data and expectations of Forex strategists. If the actual print exceeds expectations, it will make a positive impact on the US dollar. Alternatively, when this indicator falls short of expectations, the American currency will be under pressure. Ahead of a nonfarm payroll release, financial markets are usually marked by volatility. According to Forex insiders, only skilled market participants can handle trading in such a difficult period. They have already gone through a turbulent market, hence they are able to react instantly to a new data. Inexperienced traders had better close positions until the nonfarm payroll report is published. Essential to know: - The nonfarm payroll is the key barometer of the labor market. The farming industry is not taken into account because employment in agriculture depends on a season. So in winter farms hire fewer employees than in spring or summer. - Similar reports are published in Australia, Switzerland, Canada, and Germany. However, Forex is especially sensitive to nonfarm payrolls in the United States.
BUYING AND SELLING The basic idea of trading the markets is to buy low and sell high or sell high and buy low. I know that probably sounds a little weird to you because you are probably thinking “how can I sell something that I don’t own?” Well, in the Forex market when you sell a currency pair you are actually buying the quote currency (the second currency in the pair) and selling the base currency (the first currency in the pair). In the case of a non-Forex example though, selling short seems a little confusing, like if you were to sell a stock or commodity. The basic idea here is that your broker lends you the stock or commodity to sell and then you must buy it back later to close the transaction. Essentially, since there is no physical delivery it is possible to sell a security with your broker since you will ‘give’ it back to them at a later date, hopefully at a lower price. LONG VS. SHORT Another great thing about the Forex market is that you have more of a potential to profit in both rising and falling markets due to the fact that there is no market bias like the bullish bias of stocks. Anyone who has traded for a while knows that the fastest money is made in falling markets, so if you learn to trade both bull and bear markets you will have plenty of opportunities to profit. LONG – When we go long it means we are buying the market and so we want the market to rise so that we can then sell back our position at a higher price than we bought for. This means we are buying the first currency in the pair and selling the second. So, if we buy the EURUSD and the euro strengthens relative to the U.S. dollar, we will be in a profitable trade. SHORT – When we go short it means we are selling the market and so we want the market to fall so that we can then buy back our position at a lower price than we sold it for. This means we are selling the first currency in the pair and buying the second. So, if we sell the GBPUSD and the British pound weakens relative to the U.S. dollar, we will be in a profitable trade.(potential arrow image) ORDER TYPES Now it’s time to cover order types. When you execute a trade in the Forex market it is called an ‘order’, there are different order types and they can vary between brokers. All brokers provide some basic order types, there are other ‘special’ order types that are not offered by all brokers though, and we will cover them all below: Market order – A market order is an order that is placed ‘at the market’ and it’s executed instantly at the best available price. Limit Entry order – A limit entry order is placed to either buy below the current market price or sell above the current market price. This is a bit tricky to understand at first so let me explain: If the EURUSD is currently trading at 1.3200 and you want to go sell the market if it reaches 1.3250, you can place a limit sell order and then when / if the market touches 1.3250 it will fill you short. Thus, the limit sell order is placed ABOVE the current market price. If you want to buy the EURUSD at 1.3050 and the market is trading at 1.3100, you would place your limit buy order at 1.3050 and then if the market hits that level it will fill you long. Thus the limit buy order is placed BELOW the current market price. Stop Entry order – A stop-entry order is placed to buy above the current market price or sell below it. For example, if you want to trade long but you want to enter on a breakout of a resistance area, you would place your buy stop just above the resistance and you would get filled as price moves up into your stop entry order. The opposite holds true for a sell-stop entry if you want to sell the market. Stop Loss order – A stop-loss order is an order that is connected to a trade for the purpose of preventing further losses if the price moves beyond a level that you specify. The stop-loss is perhaps the most important order in Forex trading since it gives you the ability to control your risk and limit losses. This order remains in effect until the position is liquidated or you modify or cancel the stop-loss order. Trailing Stop – The trailing stop-loss order is an order that is connected to trade like the standard stop-loss, but a trailing stop-loss moves or ‘trails’ the current market price as your trade moves in your favor. You can typically set your trailing stop-loss to trail at a certain distance from the current market price, it will not start moving until or unless the price moves greater than the distance you specify. For example, if you set a 50 pip trailing stop on the EURUSD, the stop will not move up until your position is in your favor by 51 pips, and then the stop will only move again if the market moves 51 pips above where your trailing stop is, so this way you can lock in profit as the market moves in your favor while still giving the trade room to grow and breath. Trailing stops are best used in strong trending markets. Good till Cancelled order (GTC) – A good till canceled order is exactly what it says…good until you cancel it. If you place a GTC order it will not expire until you manually cancel it. Be careful with these because you don’t want to set a GTC and then forget about it only to have the market fill you a month later in a potentially unfavorable position. Good for the Day order (GFD) – A good for day order remains active in the market until the end of the trading day, in Forex the trading day ends at 5:00 pm EST or New York time. The exact time a GFD expires might vary from broker to broker, so always check with your broker. One Cancels the Other order (OCO) – A one cancels the other order is essentially two sets of orders; it can consist of two entry orders, two stop-loss orders, or two entry and two stop-loss orders. Essentially, when one order is executed the other is cancelled. So, if you want to buy OR sell the EURUSD because you are anticipating a breakout from consolidation but you don’t know which way the market will break, you can place a buy entry and stop-loss above the consolidation and a sell entry with stop-loss below the consolidation. If the buy entry gets filled for example, the sell entry and its connected stop loss will both be cancelled instantly. A very handy order to use when you are not sure which direction the market will move but are anticipating a large move. One Triggers the Other order (OTO) – This order is the opposite of an OCO order, because instead of cancelling an order upon filling one, it will trigger another order upon filling one. LOT SIZE / CONTRACT SIZE In Forex, positions are quoted in terms of ‘lots’. The common nomenclature is ‘standard lot’, ‘mini lot’, ‘micro lot’, and ‘nano lot’; we can see examples of each of these in the chart below and the number of units they each represent: HOW TO CALCULATE PIP VALUE You probably already know that currencies are measured in pips, and one pip is the smallest increment of price movement that a currency can move. To make money from these small increments of price movement, you need to trade larger amounts of a particular currency in order to see any significant gain (or loss). This is where leverage comes into play; if you don’t understand leverage totally please go read Part 1 of the course where we discuss it. So we need to know now how lot size affects the value of one pip. Let’s work through a couple of examples: We will assume we are using standard lots, which control 100,000 units per lot. Let’s see how this affects pip value. 1. EUR/JPY at an exchange rate of 100.50 (.01 / 100.50) x 100,000 = $9.95 per pip 2. USD/CHF at an exchange rate of 0.9190 (.0001 / .9190) x 100,000 = $10.88 per pip In currency pairs where the U.S. dollar is the quote currency, one standard lot will always equal $10 per pip, one mini-lot will equal $1 per pip, one micro-lost will equal .10 cents per pip, and a nano-lot is one penny per pip. HOW TO CALCULATE PROFIT AND LOSS Now, let’s move on to calculating profit and loss: Let’s use a pair without the U.S. dollar as the quote currency since these are the trickier ones: 1. The rate for the USD/CHF is currently quoted at 0.9191 / 0.9195. Let’s say we are looking to sell the USD/CHF, this means we will be working with the ‘bid’ price of 0.9191, or the rate at which the market is prepared to buy from you. 2. You then sell 1 standard lot (100,000 units) at 0.9191 3. A couple of days later the price moves to 0.9091 / 0.9095 and you decide to take your profit of 96 pips, but what dollar amount is that? 4. The new quote price for the USD/CHF is 0.9091 / 0.9095. Since you are now closing the trade you are working with the ‘ask’ price since you are going to buy the currency pair to offset the sell order you previously initiated. So, since the ‘ask’ price is now 0.9095, this is the price the market is willing to sell the currency pair to you, or the price that you can buy it back at (since you initially sold it). 5. The difference between the price you sold at (0.9191) and the price you want to buy back at (0.9095) is 0.0096, or 96 pips. 6. Using the formula from above, we now have (.0001 / 0.9095) x 100,000 = $10.99 per pip x 96 pips = $1055.04 For currency pairs where the U.S. dollar is the quote currency, calculating profit or loss is pretty simple really. You simply take the number of pips you gained or lost and multiple that by the dollar per pip you are trading, here’s an example: Let’s say you trade the EURUSD and you buy it at 1.3200 but the price moves down and hits your stop at 1.3100….you just lost 100 pips. If you are trading 1 standard lot you would have lost $1,000 because 1 standard lot of pairs with the U.S. dollars as the quote currency = $10 per pip, and $10 per pip x 100 pips = $1,000 If you had traded 1 mini-lot you would have lost $100 since 1 mini-lot of USD quote pairs is equal to $1 per pip and $1 x 100 pips = $100 You can also use this Forex Trade Position Size Calculator. Always remember: when you enter or exit a trade you have to deal with the spread of the bid/ask price. Thus, when you buy a currency you will use the asking price and when you sell a currency you use the bid price.
The word "strangle" conjures up murderous images of revenge. However, a strangle in the world of options can be both liberating and legal. In this article, we'll show you how to get a strong hold on this strangle strategy.An option strangle is a strategy where the investor holds a position in both a call and put with different strike prices, but with the same maturity and underlying asset.Another option strategy, which is quite similar in purpose to the strangle, is the straddle. A straddle is designed to take advantage of a market's potential sudden move in price by having a trader have a put and call option with both the same strike price and maturity date. While both of the straddle and the strangle set out to increase a trader's odds of success, the strangle has the ability to save both money and time for traders operating on a tight budget. Types Of StranglesThe strength of any strangle can be found when a market is moving sideways within a well-defined support and resistance range. A put and a call can be strategically placed to take advantage of either one of two scenarios:* If the market has the potential make any sudden movement, either long or short, then a put and a call can be purchased to create a "long strangle" position.* If the market is expected to maintain the status quo, between the support and resistance levels, then a put and a call can be sold to profit from the premium; this is also known as a "short strangle".No matter which of these strangles you initiate, the success or failure of it is based on the natural limitations that options inherently have along with the market's underlying supply and demand realities.Factors That Influence All StranglesThere are three key differences that strangles have from their straddle cousins:Out-of-the-money optionsThe first key difference is the fact that strangles are executed using out-of-the-money (OTM) options. OTM options may be up to or even over 50% less expensive than their at-the-money (ATM) or in-the-money (ITM) option counterparts. This is of significant importance depending on the amount of capital a trader may have to work with.If a trader has put a long strangle on, then the discount allows them to trade both sides of the fence at 50% of the costs of putting on a long straddle. If a trader is determined to put a short straddle on, then they are collecting 50% less premium while still being exposed to the problem of unlimited loss that selling options exposes a trader to.Risk/reward of limited volatilityA second key difference between a strangle and a straddle is the fact that the market may not move at all. Since the strangle involves the purchase or sale of options that are OTM, there is an exposure to the risk that there may not be enough fundamental change to the underlying asset to make the market move outside of its support and resistance range. For those traders that are long the strangle, this can be the kiss of death. For those that are short the strangle, this is the exact type of limited volatility needed in order for them to profit.Use of deltaFinally, the Greek option-volatility tracker delta plays a significant role when making your strangle purchase or sale decisions. Delta is designed to show how closely an option's value changes in relation to its underlying asset. An OTM option may move 30% or $0.30 for every $1 move in the underlying asset. This can only be determined by reviewing the delta of the options you may want purchase or sell.If you are long a strangle, you want to make sure that you are getting the maximum move in option value for the premium you are paying. If you are short a strangle, you want to make sure that the likelihood of the option expiring, as indicated by a low delta, will offset the unlimited risk. (For a refresher on how to use the Greeks when evaluating options, read Using the Greeks to Understand Options and our Options Greeks tutorial.)The Long StrangleA long strangle involves the simultaneous purchase and sale of a put and call at differing strike prices. How the different strike prices are determined is beyond the scope of this article. A myriad of choices that revolve around volatility, overbought/oversold indicators, or moving averages can be used. In the example below, we see that the euro has developed some support at the $1.54 area and resistance at the $1.5660 area.A long-strangle trader can purchase a call with the strike price of $1.5660 and a put with the strike price of $1.54. If the market breaks through the $1.5660 price, the call goes ITM; if it collapses and breaks through $1.54, the put goes ITM.In the follow-up chart we see that the market breaks to the upside, straight through $1.5660, making the OTM call profitable. Depending on how much the put option costs, it can either be sold back to the market to collect any built-in premium or held until expiration to expire worthless.The Short StrangleUsing the same chart, a short-strangle trader would have sold a call at the $1.5660 are and sold a put at the $1.54. Once the market breaks through the $1.5660 strike price, the sold call must be bought back or the trader risks exposure to unlimited losses in the event the market continues to run up in price.The premium that's retained from selling the $1.54 put may or may not cover all of the loss incurred by having to buy back the call. One fact is certain: the put premium will mitigate some of the losses that the trade incurs in this instance. Had the market broken through the $1.54 strike price, then the sold call would have offset some of the losses that the put would have incurred.Shorting a strangle is a low-volatility, market-neutral strategy that can only thrive in a range-bound market. It faces a core problem that supersedes its premium-collecting ability. This can take one of two forms:* choosing a very close range to collect an expensive premium with the odds in favor of the market breaking through the range* picking such a large range that whatever little premium is collected is disproportionately small compared to the unlimited risk involved with selling optionsConclusionStrangle trading, in both its long and short forms, can be profitable. It takes careful planning in order to prepare for both high- and low-volatility markets to make it work. Once the plan is successfully put in place, then the execution of buying or selling OTM puts and calls is simple. There is little need to choose the market's direction; the market simply activates the successful side of the strangle trade. This is the ultimate in being proactive in when it comes to making trading decisions.