As you learned earlier, when a trend moves for an extended period of time and it starts to consolidate, one of two things could happen:
- The price could continue in the same direction (continuation breakout)
- The price could reverse in the opposite direction (reversal breakout)
Wouldn’t it be nice if there was a way to know to confirm a breakout? If only there was a way to avoid fakeouts…Hmmm…
Well… THERE IS A WAY!
In fact, there are a couple of ways to tell whether or not a trend seems to be nearing its demise and a reversal breakout is in order.
Moving Average Convergence/Divergence (MACD)
By now you should have a good foundation of the MACD indicator. If you don’t, you might want to check out our lesson on MACD.
MACD is one of the most common indicators used by forex traders and for good reason. It is simple yet dependable and can help you find momentum, and in this case, the lack of momentum!
They can display MACD in several ways but one of the “sexiest” ways is to look at it as a histogram.
What this histogram does is actually show the difference between the slow and fast MACD lines.
When the histogram gets bigger, it means momentum is getting stronger.
When the histogram gets smaller, it means momentum is getting weaker.
So how can we use this when trying to spot a trend reversal? Glad you asked!
Remember that trading signal we talked about earlier called divergences and how it occurs when the price and indicators move in the opposite direction?
Since MACD shows us momentum. it would make sense that momentum would increase as the market makes a trend.
However, if MACD begins to decrease even when the trend is continuing, you can deduce that momentum is decreasing and this trend could be close to an end.
You can see from the picture that as the price was moving higher, MACD was getting smaller.
This meant that even as the price was still trending, momentum was beginning to fade out.
From this information, we can conclude that a trend reversal is highly likely.