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.