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Forex Basic Strategies

Divergence Trading – MACD Regular Divergence Forex Strategy

Introduction

MACD regular divergence is a trading strategy that considers the relationship between Moving Average Convergence Divergence and the price.

MACD, a technical indicator, invented by Gerald Appel in 1979. It is very famous among professional and institutional traders; therefore, it can provide a reliable trading opportunity. On the other hand, divergence is a significant concept in trading that happens between the price and oscillator.

In most of the cases, oscillators like MACD or RSI move with the price. However, there is some condition where MACD does not follow the same direction of the price and creates divergence.

What is the MACD Divergence Strategy?

MACD is a Momentum based indicator that shows the correlation between two moving averages. Traders use this indicator in stocks, bonds, and forex trading as a trend continuation and reversal indicator. If you want to become a successful forex trader, MACD would be the best indicator to follow.

If you use a momentum-based strategy, MACD is the best available technical indicator for you. If you trade using the MACD divergence strategy, it will show you the proper entry and exit points.

There are several types of divergence, but in most cases, investors use the following types of divergences:

Hidden Divergence

It happens when the MACD histogram creates divergence with the price. It indicates a minor market reversal and significant trend continuation.

Regular Divergence

It happens when MACD EMA moves to the opposite direction of the price. Regular divergence from a significant support or resistance level indicates a potential market reversal.

In the example below, we can see a naked chart with a MACD indicator.

If you look at the image, you can see several lower lows, and higher highs in the price and MACD EMA also followed the same direction. However, there is some point where the price and MACD did not follow the same direction as indicated in the image below.

This is how divergence forms in the price. It indicates a potential market reversal if it happens from significant support or resistance levels.

Bullish MACD Regular Divergence Trading Strategy

Bullish MACD regular divergence happens when the price of a currency pair moves to the opposite direction of the MACD histogram from a significant support level. Therefore, bullish MACD divergence strategy is considered as the positive divergence signal.

Timeframe

In this trading strategy, there is no specification of the timeframe. However, this trading strategy works well in H1 and H4 timeframe.

Currency Pair

The MACD divergence trading strategy works well in most major and minor currency pairs, including EURUSD, GBPUSD, USDJPY, and AUDUSD.

Location of the Divergence

It is essential to identify the location of the price. In this bullish divergence trading strategy, the price should form the divergence in a critical support level. Any divergence from a random place rather than a vital level would not provide good profitability. Before moving to the entry point, we should find Negative Positive and Negative (NPN) MACD histogram to form.

Entry

After forming the divergence, we should wait for a bearish reversal candlestick to enter the trade. Make sure to enter the trade as soon as the candle closes.

Stop Loss and Take Profit

In the bullish divergence trading strategy, stop loss would be below the reversal candlestick candle with 10-15 pips buffer.

The first take profit level would be based on 1:1 risk: reward, where you should close 50% of the trade and move the stop loss at breakeven. Later on, the 2nd take profit level would be based on near term event level from where the market is expected to show some correction.

However, as part of the trade management, you can extend the take profit level based on the market momentum. If the price shows an impulsive bullish pressure near the resistance level, it may break the level by creating a new high. In that case, you can extend the take profit level if your trade management system allows.

Bearish MACD Regular Divergence Trading Strategy

Bearish MACD regular divergence happens when the price of a currency pair moves to the opposite direction of the MACD histogram from a prominent resistance level. It is also considered as a negative divergence signal.

Timeframe

Similar to the bullish divergence, this trading strategy works well in H1 and H4 timeframe. You can use this trading strategy in all timeframes, but the higher timeframe provides a reliable result. On the other hand, traders often find it challenging to observe the price in daily and weekly timeframes. Therefore, H1 and H4 are ideal for swing traders.

Currency Pair

The bearish MACD divergence trading strategy works well in most major and minor currency pairs, including EURUSD, GBPUSD, USDJPY, and AUDUSD.

Location of the Divergence

It is essential to identify the location of the price. In this bearish regular divergence trading strategy, the divergence should format a significant resistance level. Any divergence from a random place would not provide good profitability.

Before moving to the entry point, we should find Positive Negative Positive (PNP) MACD histogram to form.

Entry

After forming the divergence, we should wait for a bullish reversal candlestick to enter the trade. Make sure to enter the trade as soon as the candle closes.

Stop Loss and Take Profit

In the bullish divergence trading strategy, stop loss would be above the reversal candlestick candle with 10-15 pips buffer.

The first take profit level would be based on 1:1 risk: reward, where you should close 50% of the trade and move the stop loss at breakeven. Later on, the 2nd take profit level would be based on the near term event level.

Summary

Let’s summaries the MACD regular divergence trading strategy:

  • Find the divergence based on NPN and PNP from a significant level.
  • Enter the trade after a reversal candlestick formation.
  • Stop-loss should be below or above the reversal candlestick with 10 to 15 pips buffer.
  • The first take profit would be based on 1:1 risk: reward ratio, and the second take profit would be based on the price action on the next event level.

There are more ways to use divergence as a trading strategy. Besides the divergence formation, you should focus on how the price is approaching a critical level. Any weakness at a significant level would indicate the first impression of market reversal. Later on, the divergence would indicate the final try of the opposite party. Happy Trading!

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Forex Course

133. Divergence Cheat Sheet and Summary

Introduction

The previous chapters dealt with the interpretation of divergence, its types, strategies, and the rules involved in it. In this article, we have provided a cheat sheet that will cover all the divergence topics in short.

Divergence: This a concept in technical trading that determines if the market is going to reverse or continue the trend. It is identified when the price and the indicator move in opposite directions.

Based on the direction it will prevail in, there are two types of divergence:

  1. Regular Divergence
  2. Hidden Divergence

Each of them is divided into types – Bullish and Bearish, based on the direction they are biased. Here is a quick cheat sheet for trading Regular and Hidden Divergence.

Regular Divergence

Regular divergence is divergence, which indicates a reversal in the market. These occur during the end of a trend and are quite easy to spot.

Hidden Divergence

Hidden divergence indicates a possible trend continuation. These usually occur at the beginning of a new trend and are comparatively tricky to spot.

Not all indicators can be used to spot divergence. Only momentum oscillators indicate a divergence in the market. Some of the most used momentum oscillators to determine divergence include Commodity Channel Index (CCI), Relative Strength Index (RSI), Stochastic, and William %R.

Divergence is a trading concept that works exceptionally well in some cases but fails to give the right indication sometimes. Thus, traders must follow every rule that is discussed in the previous article. We hope you found this course of Divergence trading informative and useful. Happy trading!

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Forex Course

129. Learning The Concept Of Hidden Divergence

Introduction

In the previous lesson, we discussed regular divergence and its types. In this lesson, we shall continue with the second type of divergence – hidden divergence. The concept of divergence in this type remains the same but differs in the indication it provides.

What is the Hidden Divergence?

In a trending market, the prices make higher highs or lower lows. In addition to that, it sets in higher lows or lower highs as well. When the market prepares to reverse, the lower low or higher high turns to equal high or equal low.  The higher lows or lower highs become the other way round. And in the new leg of the trend, if there is divergence, it is referred to as hidden divergence.

In simple terms, hidden divergence is used to indicate trend continuation in the middle of a trend or typically at the beginning of a new trend.

Types of Hidden Divergence

There are two types of Hidden divergence based on the direction it indicates:

  • Hidden Bullish Divergence
  • Hidden Bearish Divergence

Let’s understand how each of them is formed with examples as well.

Hidden Bullish Divergence

In a downtrend, the market makes lower lows and lower highs. In preparation for a reversal, it leaves a higher low instead of a lower low. Also, there could be a higher high or equal high. In this price action, if there is a lower low in the oscillator, it indicates a hidden bullish divergence. It signals that the price could continue to go north.

In the above chart of AUD/USD, we can see that the market is coming from a downtrend. Later, the market does not hold at S&R to make a new lower low but makes a higher low. Looking at the indicator, it leaves a lower low. Hence, showing divergence and indicating that the market has turned into an uptrend and will possibly continue its move up.

Hidden Bearish Divergence

In the market goes into a transition from an uptrend to a downtrend, the price which was making higher highs now starts to make lower highs. In addition, the oscillator puts in a higher high for the lower high in the price chart. Thus, showing a hidden bearish divergence. It is an indication that the market is going to continue in a downtrend.

In the above chart of AUD/USD, the market was initially coming from an uptrend making higher highs. Later, it turned directions and made a higher low instead of a higher high. But the RSI made a higher high for the same move. Thus, indicating divergence and most probable continuation of the downtrend.

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