Playing MACD Double Top Divergence

Although this concept is quite widely applied, its inherent value is worth repeating. As the market enjoys a trading range between its relative support and resistance levels the market will reverse direction at specific points tempting each of us to find a way to isolate those great entry points, where the potential reward far exceeds the risk, providing us with a favorable risk to reward ratio. Traders hold these situations with very high regard because we are able at times to increase the position size, as our risk can be paired down to a minimum while our possible return could significantly improve our overall account equity. So the question remains, how can we find these spots on the chart on a consistent basis?

As the market reaches and reverses direction at these critical price levels, we may see the emergence of a 'double top or double bottom' pattern. This occurs when the market tests and fails to break above (or below) a specific level at least twice and then subsequently reverses course. Let's take a look at a typical double top pattern. At times the market will break above this double top and continue to higher highs, while other times the market will in fact return to a lower price level from which it came. So far we have found a way basis to make a trade, but we still lack a qualifier or an outside source of information that will keep us far away from the losing trades, and allow us the chance to benefit from the winning trades. Although no single technique is proven accurate all the time, we can improve our success ratio by simply adding a popular technical indicator such as the MACD. The MACD histogram (in this example) measures the relationship between two exponential moving averages; 12 and 26-periods.

How to apply this indicator: As the market tests a certain price level for the second time, we should simply note the position of the MACD histogram. If the histogram registers a lower high while the market attains at least a similar high price, this shows us divergence, or in other words, a disagreement between the indicator and the market's price action it measures. On the other hand, if the MACD histogram reaches new highs as the market tests its high barrier, this convergence may indicate a likelihood of a continuation to the upside. When we spot MACD divergence as the market's trading at its highs, traders may consider selling short just below resistance with protective stops placed above the recent highs of this infamous double top. Once again, by doing so, our risk can be kept to a bare minimum while our potential profits remain significantly higher as the market confirms our reversal suspicions.

Playing MACD Double Top Divergence

Although this concept is quite widely applied, its inherent value is worth repeating. As the market enjoys a trading range between its relative support and resistance levels the market will reverse direction at specific points tempting each of us to find a way to isolate those great entry points, where the potential reward far exceeds the risk, providing us with a favorable risk to reward ratio. Traders hold these situations with very high regard because we are able at times to increase the position size, as our risk can be paired down to a minimum while our possible return could significantly improve our overall account equity. So the question remains, how can we find these spots on the chart on a consistent basis?

As the market reaches and reverses direction at these critical price levels, we may see the emergence of a 'double top or double bottom' pattern. This occurs when the market tests and fails to break above (or below) a specific level at least twice and then subsequently reverses course. Let's take a look at a typical double top pattern. At times the market will break above this double top and continue to higher highs, while other times the market will in fact return to a lower price level from which it came. So far we have found a way basis to make a trade, but we still lack a qualifier or an outside source of information that will keep us far away from the losing trades, and allow us the chance to benefit from the winning trades. Although no single technique is proven accurate all the time, we can improve our success ratio by simply adding a popular technical indicator such as the MACD. The MACD histogram (in this example) measures the relationship between two exponential moving averages; 12 and 26-periods.

How to apply this indicator: As the market tests a certain price level for the second time, we should simply note the position of the MACD histogram. If the histogram registers a lower high while the market attains at least a similar high price, this shows us divergence, or in other words, a disagreement between the indicator and the market's price action it measures. On the other hand, if the MACD histogram reaches new highs as the market tests its high barrier, this convergence may indicate a likelihood of a continuation to the upside. When we spot MACD divergence as the market's trading at its highs, traders may consider selling short just below resistance with protective stops placed above the recent highs of this infamous double top. Once again, by doing so, our risk can be kept to a bare minimum while our potential profits remain significantly higher as the market confirms our reversal suspicions.

Bollinger Band Width And Trading Ranges: When To Trade And When To Fade

The market enjoys two basic trading conditions which tend to repeat on a very regular basis; range bound and trending states. As buyers and sellers establish the extreme overbought and oversold regions, these two opposing forces begin to approach one another, and a trading range develops as relative support and resistance levels begin to approach one another. This phenomenon often times takes the shape of a triangle consolidation pattern. Eventually either the buying or selling side takes control, forcing the opposition into submission as a new trend develops and as the market trades at new highs or lows. Once this trend exhausts itself and the market fails to accomplish new highs or lows, a new range will now develop.

As the market continues to cycle between trending and ranging conditions the Bollinger Bands will continue to expand and contract based on its relative states of volatility. During trending markets the Bollinger Band Width indicator tends to rise as the bands that it measures expand away from each other. On the same note, when a range bound condition ensues the Bollinger Band Width line tends to fall as the bands contract once again towards one another. Although there may not be a notional value to gauge low or high extremes of the Bollinger Band Width line, we can approximate the ultimate high and low points by simply noting recent trading activity on the chart. More importantly we should note the direction of the Width line, as it falls after visiting extreme highs, or rises after touching extreme lows.

Now the question remains, how can we use this in our day to day trading operations? Very simply, we can see the following 2-hour chart, the GBP/USD has formed and subsequently broken out of a number of triangle patterns as the Bollinger Band Width line rises and falls respectively. As a triangle develops, we may choose to go long near support and sell short near resistance, and we may continue to do so profitably until the Width line falls to an extreme low, and then reverses to the upside. On the same note, in a trending market, we may choose to buy new highs, or sell new lows until the Width line touches an extreme high, and then reverses to the downside. Although the notional value of the Width line is important to note, the current direction of this line may be more helpful in showing us the future implied state of volatility and therefore dictate the next trade in our near future. Note how each triangle finally breaks into a new trend just as the Width line reaches an extreme low and reverses to the upside (circled below). This is typically considered the inflection point where a range becomes a trend and our view on the market must change accordingly.

Identifying Budding Trends with Bollinger Bands

Bollinger Bands are among the most commonly found technical indicators these days. Even the most basic of charting applications include them among the available offerings. There are many ways the Bands can be incorporated in to one's market analysis and trading methods (see Bollinger Bands – The Basic Rules for a discussion. This article focuses on how they can be used to find markets in the early stages of significant directional moves.

The process of trend identification using Bollinger Bands starts with evaluating the width of the Bands. This is done using the Band Width Indicator (BWI), which is calculated as follows:

BWI = ( UB – LB ) / MB

Where UB is the Upper Band, LB is the Lower Band, and MB is the Middle Band. Using the common default setting of 20-periods, that means the MB is the 20-period moving average. That default will be the one used in the examples provided herein, though it is by no means necessarily the best option.

The formula above will express the width between the Bands as a percentage of the moving average being used. It could be multiplied through by 100 to provide an integer value (as done on the sample charts). The average (MB) is used rather than current price because it is the central point in the Bands, whereas price could be anywhere within (or even outside) them.

The reason for calculating BWI is that it gives us a normalized reading of how wide the Bands are for comparative purposes. A 100 point band width on the S&P 500, for example, is relatively different when the index is at 900 than when it's at 1500. The chart below provides an example of BWI. It is a daily chart of S&P 500 e-mini futures (continuous contract) with the Bollinger Bands plotted along with price in the upper portion and BWI as the secondary plot below.

As you can see, BWI ranged between a bit below 2% and about 7% over the course of 2005. It is the lower extremes in the indicator readings which are the focus when one uses Bollinger Bands to help identify pending trends.

Continuing with USD/JPY, we can see a fairly recent example of what we are looking for here. Notice in the chart which follows, how narrow the Bollinger Bands became in September. According to BWI, they got to a width of less than 2%. Shortly thereafter, the market took off on a three month rally.

You can see from the following chart that the low BWI reading in September matched one from earlier in the year before a nice upswing in USD/JPY. It was also close to where the indicator got prior to the fall in the market late in 2004.

In the examples above, the bottom end of the BWI range was 1%-2%. For USD/JPY and some other markets such as the S&P, on a daily basis, readings that low are significant. In other markets, however, the scale is different. Look at Crude Oil, for example.

During the 12 months between August 2004 and August 2005, the lower bound was closer to 10%. That is reflective of how much more volatile Crude Oil prices were in that span than was true for other markets.

There are also differences in timeframe. Take a look at the monthly USD/JPY chart below to see how this can be the case.

Notice that BWI bottomed out around 10%, significantly above the 2% area seen on the daily chart. This, of course, is to be expected given the larger price moves which take place in that timeframe. The point, though, is that the process remains the same – look for a market situation in which BWI has reached a relatively low level in historic comparison, regardless of the timeframe in question.

What you are identifying when finding low BWI readings is markets which have been relatively range-bound for a period of time. The tendency is that the longer a market remains narrowly traded (low BWI), the more significant and explosive the move which follows. Some markets make these moves in fairly orderly fashions, as the USD/JPY example earlier. That was a fairly gradual, though quite sustained trend which began from a low BWI reading.

Other situations are more explosive. Take a look at the circled area on the S&P chart below. The BWI reading reached about 2%, which is pretty low for the index on the daily timeframe. The move which followed dropped the market 40-50 points in less than two weeks.

When reviewing BWI, it is generally not enough to just look for low readings, though. In most cases, you need to find a situation where the indicator has gotten to a relative extreme, then has begun turning higher. The reason for this is that BWI can stay low for long periods of time in some cases. The trader trying to exploit a low reading in such a circumstance, would find her/himself attempting to play a flat market, which obviously is a different type of trading than trend-hunting.

It should also be noted at this point that using BWI to indicate the end of a trend could find one leaving a considerable amount of money on the table. The example of the USD/JPY trend from September through December 2005 is a perfect example. Had one exited a long position when BWI rolled over at the start of October, about 600 pips more upside would have been missed. While a declining BWI can sometimes indicate a trend at or near its conclusion, what it is really saying is that price volatility has dropped off. In smooth, persistent trends, this happens quite often as the market just continues to grind in one direction.

Naturally, after one finds a market with a low BWI reading, there remains the task of attempting to ascertain which direction the pending move is going to take. That is an entirely different discussion, though. The Bollinger Bands themselves may not provide much help there. One is left to use other directional indications for that task. One thing to keep in mind, however, is that the initial move which gets BWI rising from a low reading may not be the one which eventually turns in to the big move. Be prepared for the fake-out maneuver. It may not always happen, but it does enough to keep traders on their toes.

There could be dozens and dozens of chart examples provide to point out how low BWI readings can indicate “trend-ready” markets. The suggestion at this point, however, is that you take a look at your favorite market in terms of BWI, and with the tools you use to determine market direction. If you are a trend trader, BWI may help you be a more successful and profitable one.