There are many opportunities in the markets everyday. Using simple tools and a keen eye are enough to find them. One of the simple tools is the difference between 2 moving averages. Derived from this indicator is a technique specifically used to identify divergence between price and indicator, called 2MA Diff. The 2 MA Diff is the difference between 2 exponential moving averages, one short-term and one long-term, plotted in a histogram with 0 as the point of equilibrium. Although the numbers plotted mark the levels, this absolute numbers are not used; it is the measurement of tops and troughs and their relationship to each other that marks the importance of its use.
In the chart above, we see that prices make a peak, pull back then make a higher peak. At the same time the 2MA Diff makes a peak, pulls back, then makes a lower peak. This is a divergence!
In Trend mechanic, 2MA Diff was calculated with the values : 8 and 17 using an exponential moving average.
Common knowledge dictates that not all indicators work 100%. So goes with this indicator. However there is one test to verify what the indicator is showing is not a false signal; and that is the use of price action to confirm the signal. The 2MA Diff indicator may lead by warning of the impending reversal but it cannot be done without the price following in the direction of the indicator. This is the test of the price action to determine if the signal is real or not.
The horizontal line from the chart above is the test of the price action to confirm the bearish divergence signal. In this example, prices did break through the horizontal line, thus confirming the signal is real.
What is this horizontal line? It is the low of the last swing low made before the second peak in prices, if there is bearish divergence. When there is bullish divergence, the horizontal line will be drawn from the high of the last swing high made before the second trough in prices.
Chart Example of Breakout Trade
If prices do not break this horizontal line and proceed to make another high or low, then this signal gets invalidated. In fact, this does not worry us since we will take the trade only if the line is violated.
The chart above shows the blue horizontal line, where the confirmation this marks threshold level. Since this pivot was the last support held by the bulls, a break of this area will get bulls exiting and bring in bears into selling. In many charts, the divergence signal will be false because price action did not follow through and not break above/below the horizontal line. The test of price action is crucial and must be used to weed out the false signals. Doing this step increases the win rate even higher.
How does one trade this divergence?
For a bearish divergence, once the price action has confirmed the signal, there are two methods to enter: (a) If the last swing low (horizontal line) is not far away from the second top, then enter on the break of the line. “Far Away” is for you to decide since your initial stop will be above the high of the second top. (b) look for the first rally, that is, the first lower high after the break of support. That rally will set up an entry. During that rally up toward the horizontal line, it is actually an act of confirming the support becoming resistance. When the bar that goes lower than the low of the previous bar’s low, that is the signal to enter a short position. Here, the stop is the horizontal line.
Where to exit?
Each trader has his or her own style or system to determine the exit: either by an absolute point system, percentage system, indicator signal or price action signal. Here are two alternatives:
1. For longs, when prices make lower high or lower low, this is indication the market is about to consolidate or reverse. An exit here is prudent. For short, when prices make higher high or higher low, it’s time to exit.
2. For shorts and longs, when the indicator makes the opposite divergence signal, the trader can consider exiting with or without price action confirmation. Either alternative is an acceptable exit point.
The blue shaded box in the above chart shows the second exit strategy: exiting from divergence signal in the opposite direction without price confirmation.
With a little patience, the indicator can pinpoint where the next opportunity is approaching. Being prepared is paramount. There is one precise entry and wait for the market to play itself out fully to truly profit, raising the reward/risk ratio much higher. Using the MACD delta indicator is simple and doesn’t require much time and maintenance to profit from the market.
