4.31 Trading with MACD Histogram Divergences
MACD Histogram was developed by Thomas Aspray in 1986 for reducing the time lag of the MACD crossover signals.
As we have seen, MACD Histogram represents the difference between the MACD and its signal line. For ready reference, in our example, the signal line or trigger line is the 9-day EMA of main MACD.
The difference between the MACD and its signal line is presented as bars. Please refer the following illustration. This "bar construction" is called MACD Histogram. You will note that after a crossover, when the gap between the MACD line and it's signal line widen ups, we get longer bars. These start becoming shorter when the gap reduces. The green bars come into the picture when price starts rising and the red ones when the price drops.
The histogram bars start showing bullish (positive) or bearish (negative) divergences well before the actual crossover and hence indicate in advance about the possibility of a reversal.
MACD generates buying or selling signals primarily as a lagging indicator even though it has some characteristics of a momentum indicator as well. This time lag may result in missing some important market moves. Because of the lagging characteristics, at times, we may get the signal quite late and hence may miss the opportunity to take the trading decision at the right time. The divergences in MACD Histogram help in speeding up the signals by enabling us to anticipate the MACD crossover in advance.
Before we go ahead, let's check what are the divergences.
Histogram with Bearish Divergence
A bearish divergence is nothing but a situation when the price-action continues to show bullishness by moving up while the technical indicator, in this case our MACD histogram, starts showing bearish signs. In simple words a bearish divergence is a divergence from the bullishness of the price-action. Bearish divergence is also termed as negative divergence. Lets have a look on the following chart to have a visual explanation:
If you see the above chart, it is clear that if you would have taken a short-selling position when the histogram started having a bearish divergence, you would have gained more pips than waiting for bearish crossover of MACD as a signal.
A word of caution here – entering into a trade is not advisable as soon as you see the initial signs of a divergence. It is better to wait for at least 4 to 5 histogram bars for confirmation.
Histogram with Bullish Divergence
A bullish divergence comes into the picture when the price-action continues to show bearishness by falling further while the technical indicator, in this case our MACD histogram, starts diverging and starts getting bullish. Bullish divergence is also termed as positive divergence at times. Check up the following chart to have a visual explanation:
The above MACD histogram chart is a good example of bullish divergence. As you can see that the bullish crossover of MACD took place long after the histogram started diverging from the price-action. However in this case a trade based on the divergence might have met the stop-loss as the actual reversal took place with the crossover. The reason is simple that the price action was choppy before that. But then, no technical indicator is always a sure shot, right?
Let’s see one more example of MACD histogram with bullish divergence:
In the above Forex chart a position based on the divergence of the Histogram would have earned a few more pips as the reversal took place well before the MACD crossover.
Histogram makes center line crossovers and divergences easily identifiable. If you look at the above Forex charts, you would note that the Histogram makes a center line crossover, whenever the MACD crosses the trigger line.
The MACD Histogram is an indicator of an indicator because this was designed to predict the movement of another indicator i.e. MACD. This may lead it to generate false signals more often as it is not “directly” connected to the “price action”. MACD is connected to the “price action” and Histogram is connected to the MACD. Hence please avoid using MACD Histogram in isolation. Either use it as an early warning system with the MACD or use it on longer time frame charts like daily chart. On short-term charts you may come across the false signals quite frequently. Another word of advice would be to have wider stop-loss levels for any positions based on histogram divergences. After all you are expecting gains of more pips, right?
- Trading With MACD Histogram Divergences