The Bearish Divergence

The Bearish Divergence

The easiest way to make money when trading in the financial markets is to buy when prices have become overly cheap, and to sell once prices have become overly expensive.  Of course this can be a difficult practice, as there is no “crystal ball” that can tell us when these important highs and lows occur.  Luckily, there are some tools that can demystify the process and one of the most common can be found in the Moving Average Convergence Divergence (MACD).  Here, I want to focus on the final word, however, as this can be a good way to determine when an uptrend has reached its exhaustion point.  When traders are looking to bet against an uptrend, bearish divergences can be used as an argument to start entering short positions.

“Perhaps the most significant advantage of the bearish divergence strategy” said Haris Constantinou, markets analyst at TeleTrade, “is that it truly allows traders to sell at the highest possible levels before the downside reversal is seen.”  Of course, when traders enter sell positions when prices are most elevated, it is easiest to maximize gains and minimize losses because the trades were placed in the optimal position.

Bearish Divergence Scenarios

In the bearish divergence scenario, you will be looking for prices to be making new highs while at the same time, the MACD indicator is failing to make a new high.  This, in essence, will signal that the bullish trend is reaching its ending point as there are not sufficient levels of momentum to carry the rally any further.

When a bearish divergence is seen, traders can enter into sell positions on the assumption that prices are likely to see declines in the future.  Similar to the bullish scenario, bearish divergences can give excellent trading signals in terms of entry levels, as traders will generally be able to enter into sell positions while prices are still near their peaks.  Since buying low and selling high is the best way to maximize gains and limit losses, many traders looking to short sell will be trying to find divergence opportunities in order to initiate their trading ideas.

Effective Strategies to Bet Against the Market

For all of these reasons, divergences can be one of the most effective ways to use the MACD indicator.  The primary benefit of trading divergences is that they can allow traders to spot potential trend reversals before most of the market has become aware that the previous trend has become over extended.  One of the best and most effective trading strategies (historically speaking) has been for traders to look for opportunities to buy low and sell high and trading with MACD divergences can be one of the easiest methods for accomplishing this.

Generally speaking, investors tend to look for places to buy assets that have become too cheap relative to historical averages.  But sometimes it is much easier to look for instances when prices have reached the opposite extreme, and to bet against all the optimism.