The Divergence and Failure Swing

Chart for this article can be found by clicking on "My Yahoo Group Site" under the files section.
File name Charts for Article 6.doc

As you may have surmised, I use only the price chart and the MACD when searching for potential trades. In essence I look for 2 things; a divergence combined with a failure swing.

A divergence occurs when price moves in a different direction then the MACD. In figure 1 of the attached file, notice that price of the NASDAQ Index reached a lower low at point B then it previous had at point A. This occurred while the MACD, at corresponding point 1, is higher then it was at corresponding point 2. After this divergence between the MACD and price, the Index moved sharply higher. Bear in mind that this alone would not prompt me to put on a trade.

Normally the term Failure Swing is associated with the Relative Strength Index. For this study I will use the term to define a very specific pattern associated with the MACD. A failure swing occurs when price action forms a reversal pattern while the MACD diverges AND the “fast line” (green line) remains below the “signal line” (white line). Again refer to figure 1, notice the double top which was formed at points C and D. Now look at the MACD in the lower window. Not only did the MACD diverge from price action at corresponding points 3 and 4, it also revealed a “Failure Swing”.

There is one last step I take before I put on the trade; I consult the longer time frames. The chart in figure 1 is a daily chart. Figure 2 is a weekly price chart and figure 3 is a monthly price chart. Notice in Figure 2 at the right hand edge of the chart, the MACD has started to flatten slightly. This provided further support for the trade.

The monthly price chart in figure 3 provides the primary foundation for the trade. The MACD at the far right edge of the chart is moving lower. In addition, it is also leading the price lower. In a later article I will discuss the term “leading the price lower or higher”.

We have now created the most basic framework for my trading style. From this point forward most of my articles will use price chart examples to explore the more detailed intricacies of trading.

Call or email with any questions,

Bob

PS; After reviewing the copied charts, I see that it is difficult to see the MACD flattening in figure 2. To show this more clearly I have added figure 4 which contains the MACD Osc (histogram). Here we can see that the MACD momentum is slowing. Remember from the article titled Introduction to the MACD, the histogram shows a bar graph representation of the distance between the 2 lines.

The MACD Indicator

The Moving Average Convergence/Divergence Indicator or MACD has long been revered as the most accurate indicator. As a momentum indicator, the MACD tells us if the price movement is trending as well as the strength and direction of the trend. But more importantly, when use in conjunction with a price chart it has the uncanny ability to identify tops and bottoms with almost perfect accuracy. Of course one must learn to speak its subtle language.

The MACD can be used with any time frame from a 15 minute price chart to a monthly price chart. By fully understanding the MACD, a trader or investor can develop an excellent trading or investing plan. What’s more, this indicator works for all price charts I have studied, from stocks to futures to currencies. It is not necessary to know how this indicator is computed. You only need to know how to use it properly.

The MACD is normally comprised of 2 lines, the fast line and the slow line. I will refer to the slow line as the signal line. At times the indicator will include a “histogram” or bar graph representing the distance between the 2 lines. In addition, the histogram indicates which line is on top. I do not normally use the histogram and do not include it in my charting. If I cannot tell what is occurring using the 2 lines of the basic MACD, I do not trade.

The slope and relationship of these 2 lines tell us what is happening to price momentum and at times what is likely to happen in the future. Keep in mind the MACD cannot predict every price reversal but the reversals that it does forecast can be exceptionally accurate when it is taken into context with the general market. By this I mean if the Dow Jones Industrial Average, the S&P 500 and NASDAQ indexes are trending higher, a MACD “up signal” issued for an individual stock will almost always be accurate. The opposite can be said as well; in a down market a MACD “down signal” issued for a single equity is almost always correct.