Convergence-Divergence FX Strategy

Introduction

The basis of the MACD divergence strategy is the fact that the MACD is a leading indicator which sometimes points to change in trend of price action, before the price action itself moves in the direction of the MACD indicator.

Indicators

The only indicators used for this strategy is the modified MACD histogram which is colour-coded. Additionally, the trader may opt to use the line tool to trace the highs and lows of price action, which will be used to make comparisons to the MACD highs and lows in order to pick out areas of convergence and divergence that are traded in the strategy.

The Strategy

The basis behind the strategy is simple. The MACD indicator has a histogram component whose highs and lows correspond to the highs and lows of price action. However, there will be periods in time when the highs and lows of the MACD histogram will be out of sync with those of the price action candles. This will eventually correct itself. So the essence of the trade is to identify this period when price action and MACD are out of sync, and then put in the trade so that the correction of this convergence/divergence will yield profit.

The Short Trade (trading the divergence)

The MACD histogram forms valleys and peaks corresponding to similar valleys and peaks of the price action. There will be occasions when the valleys and peaks of both price action and the MACD histogram will deviate from their synchronized movement. This creates market opportunity, because this deviation will eventually correct itself. The divergence trade is therefore set in the direction of the expected correction.

What is the divergence? The MACD has lower highs when price action forms higher highs. The price is expected to correct itself downwards. The divergence trade will therefore be to go short on the currency pair, using clear cut technical entry parameters. These technical entries could be made using:

  1. Price located at a resistance pivot points.
  2. Break of a trendline which joins the lows of price action to the downside.
  3. Strongly bearish candlestick formations such as the evening doji star.

The snapshot below illustrates the entry parameters:

MACD_diverg

MACD Divergence Trade Setup

This is an example of a typical divergence trade setup. For this trade, we see the price action forming higher highs when the MACD histogram is forming lower highs. Then we have a bearish engulfing candlestick setup forming at the R2 pivot resistance. These two technical setups are a perfect signal to go short on the open of the candle following the bearish engulfing pattern. Furthermore, the MACD histogram was red in colour, supporting the short trade entry.

Stop Loss

For this example, the stop loss can be set at some pips above the R2 resistance area.

Take Profit

Technical parameters must be used in deciding the exit point for the divergence trade. A good place would be at the R1 resistance area as 1st target. If price action candle had broken this area, then the logical thing would have been to setup a trailing stop at R1 to chase the price even lower to the central pivot point.

2) The Long Trade (trading the convergence)

Sometimes, the situation is that the MACD histogram forms higher lows when the price action is forming lower lows. This also creates market opportunity because the price action will attempt a correction in an upward direction. The long trade is therefore used to profit from this upward correction. Once more, technical parameters are used in performing the trade entry.

  1. Price located at a support pivot point.
  2. Break of a trendline which joins the highs of price action to the upside.
  3. Strongly bullish candlestick formations such as the bullish engulfing candle pattern.

The snapshot below shows a typical convergence trade, using one of the long entry parameters listed above:

MACD_converg

MACD Convergence Trade Setup

In this example, we decided to use a different technical parameter for trade entry, as evidenced by the use of the trendline break of price highs of the first few candles following the identification of the convergence trade setup. A trendline was drawn across the high prices of a few candles, and we look for a break of this trend line transient resistance to confirm the move higher. After a few pinbars formed, the price action broke this trend line and started the gradual move upwards.

Stop Loss

In this instance, the stop loss would be placed not just below the trend line, but also below the lows of the few candles used in the calculation.

Take Profit

The trader is at liberty to decide how to take profit in this instance. The choice can be made from a number of options:

  1. Setting the TP at double or triple the number of pips that the stop loss was set at.
  2. Using a reversal pattern to exit the trade.

The strategy can be traded on any time frame. But if you need quick profits, the one hour chart will work just well for this trade strategy, especially when entries are made with the pivot points.

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