SCOTT WELSH TRADING BLOG

Is Divergence The Secret To Profitable Trading?

Is Divergence The Secret To Profitable Trading?

Apr. 10, 2019

What’s the best way for traders to make a profit?

It’s not index funds (much more on that to come).

It doesn’t appear to be price action. The price action we’ve looked at has always come up short.

It could be indicators. We’ve seen a lot of profitable systems using indicators, but there’s no denying that indicator trading can (and will) have drawdowns.

Is there a “best” way?

What about divergence? Divergence appears to combine the best of everything. It uses price action and indicators in an effort to give us powerful signals.

Let’s take a look.

The first problem with divergence is that it’s hard to pin down. What is it exactly?

Philosophically, divergence is when price goes down but the indicator goes up. Price is making a new low, but the indicator is definitely not making a new low. What does that mean?

It means that the new low on our screen is temporary. It’s weak. It’s not really bad news at all.

If price is making a new low, everything should be making a new low. We saw this many times in the crisis of 2008-09. Both price and indicators were falling off the table at the same time.

But when price falls while an indicator rises, it’s the scared-y cats that are selling. The “smart money” isn’t so sure things are bad. The smart money thinks the new low is about to turn around.

Or so the thinking goes.

Does it work?

For our research, we’re using the MACD as our indicator. If price makes a new low but the MACD is actually higher than it was at the previous low, that constitutes divergence for us, and we’re looking for a trade.

How will we get in the trade? We’ll use one of our favorite indicators, the RSI.

Last, we’ll use a filter. If we get divergence above the 200 SMA, we’ll look for a Long trade. If we get divergence below the 200 SMA, we’ll look for a Short trade.

And we’ll use one of our favorite currency pairs, the EURUSD, and put it on a Daily chart so our signals are more powerful.

Here are the details:

  • System: The MACD Divergence System
  • Philosophy Behind It: Divergence is a powerful tool; let’s use it to give us the best trades
  • Need Special Indicators? Yes. A Divergence indicator. Or Divergence can be determined with the naked eye.
  • Chart: Daily
  • Instrument: Forex EURUSD
  • Long or Short? Both
  • MACD Settings: 12-26-9 (default settings)
  • Long Entry: 1) There must be MACD divergence (new low, higher MACD); 2) Price above the 200 SMA; 3) RSI (length 4) must close into Oversold (30); 4) Trade is taken at the close of the bar
  • Short Entry: 1) There must be MACD divergence (new high, lower MACD); 2) Price below the 200 SMA; 3) RSI (length 2) must close into Overbought (70); 4) Trade is taken at the close of the bar
  • Stop Loss: 159 pips
  • Take Profit: 52 pips
  • Special Caveat: If price reaches the profit target in the very next bar, then we exit at the Open of the next bar; this may give us bigger winners if price moves quickly in our favor after Divergence
  • Trade size: 1.0 lots
  • Hypothetical Profit: $15,683 (no compounding)
  • Hypothetical Max Drawdown: $2,735
  • Hypothetical account size: $5,000-10,000
  • Test Period: 2001-2019
  • Number of Trades: 26

Here’s the Tradestation Performance Report:

The big thing to notice right away is the low drawdown. We thought Divergence was a powerful tool, and, thus, we thought it would be a great filter to use to pick trades. That appears to be true right off the bat.

And the win percentage sure isn’t terrible (88%).

Because of the low drawdown, we could use as small as a $5,000 account with 1 full lot if we could handle a 33% close-to-close drawdown. If we did that, this system would beat the market nicely over this time period.

A negative is the amount of trades. There aren’t a lot.

But that’s what we expected when choosing Divergence, right? We’re waiting for a really strong signal, not just any signal. If we wait for Divergence, we’re not diving into the market on any little thing.

So, after our first look, it seems like Divergence is what we hoped it was.

In our next email, we’ll forget Divergence and see if it’s all smoke and mirrors. And in the the YouTube video this week, I’ll break down this trade in more detail. It’s kind of hard to understand without pictures.

Talk to you soon.

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Disclaimer:
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these sites are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. The authors, the publisher, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.