Two strategies for trading Price / Indicator Divergences

by | February 5th, 2018, 10:15:37 | Education | 4 comments

Technical analysis

For this example I will use two of the more widely known and frequently used Oscillators – MACD Moving Average Convergence Divergence and the RSI Relative Strength Index.

 

MACD  – Is a lagging Oscillator based on 3 EMA’s calculated from historical price data. I have to come clean at this point and confess that lagging Indicators have no place on my trading charts. There is only one of this group that I have any time for – Ichimoko Kinko Hyo .
RSI – Is a leading Oscillator that measures the relative changes that occur between higher and lower closing prices – I use RSI on the Hourly setting on at least one of my chart set ups at all times without taking much notice of the conventional settings and standard protocols commonly used for applying the indicator.
A Divergence occurs when Price Vs Indicator levels are out of sync. As always, placing your faith in any Indicator is problematic and foolhardy. The sensible approach is to always ‘overlay’ other methods that you use and trust to try and maximize the potential for success. For me this would include simple support / resistance, fib levels and extensions, Trendlines and Candle structure .
Below is an example of a rather robotic method that I have come across using the MACD. I do not use it myself as stated, but have a successful trader friend who swears by it. …………… Best used on 1 Hour charts for catching the smaller moves. I have removed the 9 period EMA trigger line and signal to show Histogram only. The  ‘Rules of engagement’ are explained on the chart . Place a horizontal line at the lowest Histogram Bar in the dip between the 2 peaks that form the (in this case negative) divergence – This becomes the Trigger line.- Exit on the first bar that prints higher or lower ( depending on whether the divergence is positive or negative = Long or Short Trade direction ). The example below shows a short trade – For a long trade simply reverse the method.

EURAUD Hourly MACD Method.

Another example below of a small win

EURAUD Hourly MACD Method

The following chart shows a wider view of the above trades with a Long trade set up (positive divergence) in-between the short trades highlighted by the blue lines – Worth noting that although price extended to the upside, the Bar count would have dictated exiting the trade very early.

 

EURAUD Houly MACD Method

 

On to the RSI .- Modify your settings to show a 40 and 60 level and disregard the standard 30 – 70. Simple rules for this one……….. Once a divergence has been identified, enter and exit using the modified levels — Use the 60 level to enter and exit short trades — Use the 40 to enter and exit long trades.

 

EURAUD Hourly RSI Method

 

The chart below shows a comparison between the 2 methods

 

EURAUD Houly – Compare MACD / RSI

 

— IN CONCLUSION —  Both give false starts. On back testing, many of the failures will be at the break even trade entry, a little frustrating but not altogether disastrous. I prefer the RSI strategy to the MACD. Far simpler and clearer to view on the charts with no Bar counting involved. I would not be tempted to use either of these methods on anything under a 1 hour timeframe as there is too much price noise in markets to chance picking out divergences successfully on anything less. Entering when the Indicators are stretched at visible highs / lows would also give a better chance of a successful outcome.

My thanks to Stefan in the comments who requested this post. We always like to go that extra mile here on ForexFlow to keep our friends and readers happy even when it interferes with my lunch break  🙂  It has given me an opportunity to review these Indicators again for myself ………….. That’s the great thing about trading – We never stop learning. 

Horatio Dubsly
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