Trading The MACD Divergence

I think this is a great article on the use of macd in your trades!

by Boris Schlossberg,
Moving average convergence divergence (MACD), invented in 1979 by Gerald Appeal, is one of the most popular technical indicators in trading. MACD is appreciated by traders the world over for its simplicity and flexibility because it can be used either as a trend or momentum indicator.

Trading divergence is a popular way to use MACD histogram (which we explain below), but, unfortunately, the divergence trade is not very accurate - it fails more than it succeeds. To explore what may be a more logical method of trading MACD divergence, we look at using the MACD histogram for both trade entry and trade exit signals (instead of only entry), and how currency traders are uniquely positioned to take advantage of such a strategy.

MACD: An Overview
The concept behind MACD is fairly straightforward. Essentially, it calculates the difference between an instrument's 26-day and 12-day exponential moving averages (EMA). Of the two moving averages that make up MACD, the 12-day EMA, is obviously the faster one, while the 26-day is slower. In the calculation of their values, both moving averages use the closing prices of whatever period is measured. On the MACD chart, a nine-day EMA of MACD itself is plotted as well, and it acts as a trigger for buy and sell decisions. MACD generates a bullish signal when it moves above its own nine-day EMA, and it sends a sell sign when it moves below its nine-day EMA.

The MACD histogram is an elegant visual representation of the difference between MACD and its nine-day EMA. The histogram is positive when MACD is above its nine-day EMA and negative when MACD is below its nine-day EMA. If prices are rising, the histogram grows larger as the speed of the price movement accelerates, and contracts as price movement decelerates. The same principle works in reverse as prices are falling. See Figure 1 for a good example of a MACD histogram in action.

Figure 1: MACD histogram. As price action (top part of the screen) accelerates to the downside, the MACD histogram (in the lower part of the screen) makes new lows

Source: FXTrek Intellicharts

The MACD histogram is the main reason why so many traders rely on this indicator to measure momentum, because it responds to the speed of price movement. Indeed, most traders use the MACD indicator more frequently to gauge the strength of the price move than to determine the direction of a trend.

Trading Divergence
As we mentioned earlier, trading divergence is a classic way in which the MACD histogram is used. One of the most common setups is to find chart points at which price makes a new swing high or a new swing low but the MACD histogram does not, indicating a divergence between price and momentum. Figure 2 illustrates a typical divergence trade.

Figure 2: a typical (negative) divergence trade using a MACD histogram. At the right-hand circle on the price chart, the price movements make a new swing high, but at the corresponding circled point on the MACD histogram, the MACD histogram is unable to exceed its previous high of 0.3307. (The histogram reached this high at the point indicated by the lower left-hand circle.) The divergence is a signal that the price is about to reverse at the new high, and as such, it is a signal for the trader to enter into a short position.

Source: Source: FXTrek Intellicharts

Unfortunately, the divergence trade is not very accurate - it fails more times than it succeeds. Prices frequently have several final bursts up or down that trigger stops and force traders out of position just before the move actually makes a sustained turn and the trade becomes profitable. Figure 3 demonstrates a typical divergence fakeout, which has frustrated scores of traders over the years.

Figure 3: A typical divergence fakeout. Strong divergence is illustrated by the right circle (at the bottom of the chart) by the vertical line, but traders who set their stops at swing highs would have been taken out of the trade before it turned in their direction.

Source: Source: FXTrek Intellicharts

One of the reasons that traders often lose with this set up is they enter a trade on a signal from the MACD indicator but exit it based on the move in price. Since the MACD histogram is a derivative of price and is not price itself, this approach is, in effect, the trading version of mixing apples and oranges.

Using the MACD Histogram for Both Entry and Exit
To resolve the inconsistency between entry and exit, a trader can use the MACD histogram for both trade entry and trade exit signals. To do so, the trader trading the negative divergence takes a partial short position at the initial point of divergence, but instead of setting the stop at the nearest swing high based on price, he or she instead stops out the trade only if the high of the MACD histogram exceeds its previous swing high, indicating that momentum is actually accelerating and the trader is truly wrong on the trade. If, on the other hand, the MACD histogram does not generate a new swing high, the trader then adds to his or her initial position, continually achieving a higher average price for the short.

Currency traders are uniquely positioned to take advantage of this strategy because with this strategy, the larger the position, the larger potential gains once the price reverses - and in FX, you can implement this strategy with any size of position and not have to worry about influencing price. (Traders can execute transactions as large as 100,000 units or as little as 1,000 units for the same typical spread of three to five points in the major pairs.)

In effect, this strategy requires the trader to average up as prices temporarily move against him or her. This, however, is typically not considered a good strategy. Many trading books have derisively dubbed such a technique as "adding to your losers". However, in this case the trader has a logical reason for doing so - the MACD histogram has shown divergence, which indicates that momentum is waning and price may soon turn. In effect, the trader is trying to call the bluff between the seeming strength of immediate price action and MACD readings that hint at weakness ahead. Still, a well-prepared trader using the advantages of fixed costs in FX, by properly averaging up the trade, can withstand the temporary drawdowns until price turns in his or her favor. Figure 4 illustrates this strategy in action.

Figure 4: The chart indicates where price makes successive highs but the MACD histogram does not - foreshadowing the decline that eventually comes. By averaging up his or her short, the trader eventually earns a handsome profit as we see the price making a sustained reversal after the final point of divergence.

Source: Source: FXTrek Intellicharts

Conclusion
Like life, trading is rarely black and white. Some rules that traders agree on blindly, such as never adding to a loser, can be successfully broken to achieve extraordinary profits. However, a logical, methodical approach for violating these important money management rules needs to be established before attempting to capture gains. In the case of the MACD histogram, trading the indicator instead of the price offers a new way to trade an old idea - divergence. Applying this method to the FX market, which allows effortless scaling up of positions, makes this idea even more intriguing to day traders and position traders alike.


To Your Trading Success!

Day Trading Diary 20th 0ct 09

I have had two classic Pound dollar trades this week. Its been very consistent and unlike yesterday I made sure I was in the trade! The skype trading group had a big difference of opinion this morning. Some played the breakout strategy while others went long using the pivot strategy also on pound dollar.

It took me 5 Min's to get my pips after the movement at 7.10am, what has made the trades classic is the way it has been channeling. It means the breakout is very clear and less risky. As I said I chose not to play the pivot strategy and took 20 pips as a breakout with limit set for 30 (Just in case).



At the time of the screen shot it looks like cable is showing in decision. It actually reversed and a few people lost. Just a question of experience really I do trust the pivot strategy but did not trust the time. I have much work to do this week, I have two trading plans to review as well as a months trading results of one of the new advanced traders.

Great news to hear that J (Wont give her real name) took action after my consultation and has created her trading plan. She is going to do very well and won her first trade! If you would like additional coaching please e-mail me at Kofi.oppong1@btinternet.com

To Your Trading Success!

Day trading diary Mon Oct 17th 09

Markets were buoyant today, unfortunately I missed all the major moves. Because of this it will only be a quick update.I only took 8 pips and really don't want to be reminded of my misses! Lots on this week with teaching on Friday and meetings booked all over the place.



The pound yen had a big move down as well this morning. I counted 4 pairs that awoke from slumber at 8am for some crazy reason. Apart from ftse opening there was nothing special that I knew of that would affect the markets at that time? It just seemed like 8 was the magic number today!



Off to do some other things today, hope the trading community had a better morning than mine!

To Your Trading Success!

Trading Diary 16th October 09

Just one of those days....Great track by Monica and I should remember the second verse "Don't take it personal" What am I on about? Well I woke up and my 3 network was down. It decided to begin working again at 7.30.

When I logged on my favourite trade which is the Pound Dollar forex breakout, was done and dusted. It was a very nice move but sadly I was not in it and missed 30 easy pips and more. I would have ended the week on 120 pips if I had placed this trade!

(Cable Breakout)


Forex Pivot Strategy

I have found the grey background seems to give a better picture so you can see the trade. I will now show more on this strategy's performance. You can now view the trades much more clearly to compare on your own charts.

Some great moves this week and very successful, I unfortunately missed the best one today on the Euro Dollar. I play this strategy by setting oto's (Order To Open) but was too late after Internet connection to place the trade.

I then ended up in a Dollar Yen trade but went out and missed break even. It went wrong so I cut my losses and ended the week up 60 pips! As I said I wont take it personal!


Its Friday again and I have Arsenal to bash Birmingham to look forward to! A good week with the highlight of meeting Brad Sugrars of Action Coach on Wednesday. You gain an understanding of why top people like him are successful. I took away lots on business that I can implement straight away.

I shall be teaching the new advanced traders next Friday. With a more mechanical ForexStrategy it is even easier to pick up.

Have a great weekend all!

Trading Diary Thurs 15th Oct 09

Did not trade yesterday as I attended the Brad Sugar event on business in Fulham. Got a nice 17 pips early morning on cable today, the nice type of in and out trade in 5 minutes. When I woke at 5.50 am gbp/usd had been channeling very nicely.

It made one attempt to break the mid pivot at 16072. It actually reached 16074 but I refused to take the trade because it was not 7 am and when Frankfurt opens it can send it anywhere.

It retracted and then dropped for two candles before going long. All signs were looking good so I entered the trade as soon as it broke the mid pivot again at16073 and exit 5 minutes later before the main resistance pivot line at 16100.



From my entry time of around 7.15am cable moved over 100 pips for the next three hours. No real reason for the move but plenty on offer.

I also traded usd/jpy for 15 pips and a sneaky trade on Eur/usd for 15 pips also. The latter two trades were using the pivot strategy that I have been testing and is now live.

Recession still on every ones mind, but if you follow the markets you will know that wall st is trying to break records. Interesting if you also follow the doom and gloom mentality of the press!

To Your Trading Success!

Dear Diary I lost Again - Shit No Trading Plan!

I have touched on this subject before, but I have recently been speaking to many traders and incredibly there are still many unaware of the importance of having a living breathing trading plan. So I thought I would revisit what it is and why you need one!

Not having a Trading Plan is as close to suicide as you can get in trading!

If you believe you can trade without one I suggest you donate your money to me or leave your front door open all night for a week! There are many ways to create a trading plan and I have included an article form investopedia which will help.

I have now really simplified my trading plan based around me. An example of this is my trading plan rule one "Mechanical Trading" I trade on set strategies which have a high success rate. Mechanical Trading means to me "Just Follow The Rules" I have a tendency to tinker with the strategy based on being a mechanic profile according to wealth Dynamics.

This also means I am not a natural at reading the markets and it could take me longer to reach a level of consistency, unlike someone like George Soros.

Because of this I tell myself everyday to follow the rules. Another example could be " When I have placed the trade I will not sit in front of the computer and watch" If you are emotional about watching money go up and down this is a must. Or switch that part of the screen off! Build some of your faults that you have into your plan.

If you are new congratulations, follow the rules below and you will save yourself a lot of pain and a hell of a lot of MONEY!

Building the Perfect Master Plan
What are the components of a good trading plan? Here are 10 essentials that every plan should include.

1. Skill assessment - Are you ready to trade? Have you tested your system by paper trading it and do you have confidence that it works? Can you follow your signals without hesitation? If not, it's a good idea to read Mark Douglas's book, "Trading in the Zone", and do the trading exercises on pages 189–201. This will teach you how to think in terms of probabilities. Trading in the markets is a battle of give and take. The real pros are prepared and they take their profits from the rest of the crowd who, lacking a plan, give their money away through costly mistakes.
   
   
2. Mental preparation – How do you feel? Did you get a good night's sleep? Do you feel up to the challenge ahead? If you are not emotionally and psychologically ready to do battle in the markets, it is better to take the day off - otherwise, you risk losing your shirt. This is guaranteed to happen if you are angry, hungover, preoccupied or otherwise distracted from the task at hand. Many traders have a market mantra they repeat before the day begins to get them ready. Create one that puts you in the trading zone.
   
   
3. Set risk level – How much of your portfolio should you risk on any one trade? It can range anywhere from around 1% to as much as 5% of your portfolio on a given trading day. That means if you lose that amount at any point in the day, you get out and stay out. This will depend on your trading style and risk tolerance. Better to keep powder dry to fight another day if things aren't going your way.
   
   
4. Set goals – Before you enter a trade, set realistic profit targets and risk/reward ratios. What is the minimum risk/reward you will accept? Many traders use will not take a trade unless the potential profit is at least three times greater than the risk. For example, if your stop loss is a dollar loss per share, your goal should be a $3 profit. Set weekly, monthly and annual profit goals in dollars or as a percentage of your portfolio, and re-assess them regularly.
   
   
5. Do your homework – Before the market opens, what is going on around the world? Are overseas markets up or down? Are index futures such as the S&P 500 or Nasdaq 100 exchange-traded funds up or down in pre-market? Index futures are a good way of gauging market mood before the market opens. What economic or earnings data is due out and when? Post a list on the wall in front of you and decide whether you want to trade ahead of an important economic report. For most traders, it is better to wait until the report is released than take unnecessary risk. Pros trade based on probabilities. They don't gamble.
   
   
6. Trade preparation – Before the trading day, reboot your computer(s) to clear the resident memory (RAM). Whatever trading system and program you use, label major and minor support and resistance levels, set alerts for entry and exit signals and make sure all signals can be easily seen or detected with a clear visual or auditory signal. Your trading area should not offer distractions. Remember, this is a business, and distractions can be costly.
   
   
7. Set exit rules – Most traders make the mistake of concentrating 90% or more of their efforts in looking for buy signals but pay very little attention to when and where to exit. Many traders cannot sell if they are down because they don't want to take a loss. Get over it or you will not make it as a trader. If your stop gets hit, it means you were wrong. Don't take it personally. Professional traders lose more trades than they win, but by managing money and limiting losses, they still end up making profits.
   
   Before you enter a trade, you should know where your exits are. There are at least two for every trade. First, what is your stop loss if the trade goes against you? It must be written down. Mental stops don't count. Second, each trade should have a profit target. Once you get there, sell a portion of your position and you can move your stop loss on the rest of your position to break even if you wish. As discussed above in number three, never risk
more than a set percentage of your portfolio on any trade.


8. Set entry rules – This comes after the tips for exit rules for a reason: exits are far more important than entries. A typical entry rule could be worded like this: "If signal A fires and there is a minimum target at least three times as great as my stop loss and we are at support, then buy X contracts or shares here." Your system should be complicated enough to be effective, but simple enough to facilitate snap decisions. If you have 20 conditions that must be met and many are subjective, you will find it difficult if not impossible to actually make trades. Computers often make better traders than people, which may explain why nearly 50% of all trades that now occur on the New York Stock Exchange are computer-program generated. Computers don't have to think or feel good to make a trade. If conditions are met, they enter. When the trade goes the wrong way or hits a profit target, they exit. They don't get angry at the market or feel invincible after making a few good trades. Each decision is based on probabilities.
   
9. Keep excellent records – All good traders are also good record keepers. If they win a trade, they want to know exactly why and how. More importantly, they want to know the same when they lose, so they don't repeat unnecessary mistakes. Write down details such as targets, the entry and exit of each trade, the time, support and resistance levels, daily opening range, market open and close for the day, and record comments about why you made the trade and lessons learned. Also, you should save your trading records so that you can go back and analyze the profit/loss for a particular system, draw-downs (which are amounts lost per trade using a trading system), average time per trade (which is necessary to calculate trade efficiency), and other important factors, and also compare them to a buy-and-hold strategy. Remember, this is a business and you are the accountant.
   
10. Perform a post-mortem – After each trading day, adding up the profit or loss is secondary to knowing the why and how. Write down your conclusions in your trading journal so that you can reference them again later.

As a tip and while you are learning I would recommend FAPTURBO to build up your pot. They are now extremely reliable and will keep you winning while you learn to trade! I know people who are doing exactly that to beat the markets while they donate to the spreadbetting funds during early years of trading.



To Your Success!

Trading Diary 13th Oct 09

After two weeks of events and meetings I finally get to update my blog with some trades. Early morning cable breakout yielded a nice 15 pips below. Had I stayed in longer there was 30 pips on offer.

My trading style means I pay less attention to the long term trends or resistance lines many of the forum guys focus on. Your comments would be appreciated if that would be useful.



The recent advanced traders have been making some really strong pips.
Mainly using the new Pivot strategy on Forex but also trading the old ftse strategy modified for the Dax by Phill.

Whats even more important is they trade without fear. The key area were trading is won or lost. Phill is now looking after most of the analysis for the group and is doing a fantastic job.

In recent analysis it has emerged that the oil trade is our most successful with only 1 loss since since April. If you follow the rules you would have gained 450 pips so far this year. I am now playing this strategy when the signs are correct!

The new pivot strategy on forex is working really well. Not happy with quality on charts so will adjust them so they are better to view the trades. Meta trader takes some getting used to.


Fantastic Trading!

Speaking At The Property Pin Event For Simon Zushi!

On Saturday the 26th September I talked at the Simon Zushi property network events for his previous graduates, about the psychology of trading.

Simon as a property entrepreneur has always used different techniques to to improve the mindset of his property students, when teaching them the various strategies to build a property portfolio.

In previous events he has used wealth dynamics to encourage team building among his students and also to identify what different qualities you may need in your own mastermind team to be successful.

(Franscois, Simon Zushi, Janine and me...Dinner and school disco event)

Trading is very similar and requires Discipline (Which means repeating the good things that you do - Not as most people believe - Hard work!) It also requires you to take action and not least to conquer your fears.

I was part of the first mastermind group that Simon began with almost two years ago and have since as you know, evolved to trading.

But the learning I gained will support where I place my profits from trading, as I build assets for my future and create additional passive income.

It was a pleasure to speak in front of other mastermind groups as well as my own. In addition I would highly recommend Simon if you you decide to take up property. He is extremely ethical and his teaching of property is the best around.

We ended the night with a reunion dinner with a school dinner theme! Very entertaining!

I ended my speech with the classic quote of Albert Einstein:

Insanity is doing the same thing over and over again and expecting different results!

What are you doing to achieve your goals? Are you on the rat wheel turning over and over again but not really going anywhere? Without asking yourself this question everyday you will find life a huge struggle to improve.

To Your Trading Success!