Strongest Signal in Technical Analysis
MACD Histogram Divergence

Alexander Elder describes the divergence between the peaks and bottoms of share price and the MACD Histogram as the strongest signal in technical analysis. According to him, this powerful signal only occurs once or twice per year on a daily chart. 

A divergence occurs when the trend of price highs and lows goes one way and the trend of tops and bottoms in MACD Histogram goes the opposite way. Those patterns take several weeks or even more than a month to develop on daily charts.

BULLISH DIVERGENCE - A bullish divergence occurs when prices trace a bottom, rally and then sink to a new low. At the same time, MACD Histogram traces a different pattern. When it rallies from its first bottom, that rally lifts it above the zero line, "breaking the back of the bear". When prices sink to a new low, MACD Histogram declines to a more shallow bottom. At that point, prices are lower, but the bottom of MACD Histogram is higher, showing that bears are weaker and the downtrend is ready for a reversal. MACD Histogram gives a Buy signal when it ticks up from its second bottom.

Occasionally, the second bottom is followed by a third. This is why traders must use stops and proper money management. There are no certainties in the markets, only probabilities. Even a reliable pattern such as a divergence of MACD Histogram fails occasionally, which is why we must exit if prices fall below their second bottom. We must preserve out trading capital and re-enter when MACD Histogram ticks up from its third bottom, as long as it is higher than the first.

BEARISH DIVERGENCE - A bearish divergence occurs when prices rise to a new high, decline, and then rise to a higher peak. MACD Histogram gives the first sign of trouble when it breaks below its zero line during the decline from its first peak. When prices reach a higher high, MACD Histogram rises to a much lower high. It shows that bulls are weaker, and prices are rising simply out of inertia and are ready to reverse.

MetaStock Formula 

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