MACD, short for moving average convergence divergence, is a trading indicator used for technical analysis. It was created by Gerald Appel in the late 1970s.
It is designed to reveal changes in the strength, momentum, and duration of a trend in a currency pair or stock’s price.
Before proceeding any further, learn all about the MACD indicator here.
The working principle of this indicator is easy. It uses two exponential moving averages with different periods for its calculations.
The most commonly used setting for a MACD indicator is the (12, 26, 9).
Interpreting this, 12 represents the faster-moving average while 26 represents the slower moving average.
Here comes this tricky part; the 9 means that the average of the indicator itself is taken for the past 9 days.
The MACD gives a bullish signal when it moves above its 9-day EMA and a sell sign when it moves below its 9-day EMA.
Furthermore, the histogram indicates the magnitude of bullish or bearish momentum. It graphs the difference between the MACD and the signal line.
The higher the speed of price, the larger the histogram becomes. When the price stalls, the histogram diminishes.
The MACD settings can be customized for required needs. Although, backtesting and forward testing should be conducted after the settings have been altered.
This way, performance, and accuracy can be approximated without risking capital.
Ways To Trade With The MACD
There are two major ways to trade with this indicator:
- MACD crossover
- MACD divergence
The MACD line reacts faster than the signal line. When the MACD line crosses the signal line, they start to move away from each other. This shows the start of a new trend.
The histogram always reads zero when this cross-over occurs. This is because the difference between the lines when they crossover is zero as well.
When the fast line crosses ABOVE the slow line, indicates the start of an uptrend. The histogram will be above the baseline.
Conversely, if the fast line crosses BELOW the slow line, it is a bearish signal indicating the start of a downtrend. The histograms display below the baseline in this case.
It is important to note that crossovers are more reliable when they conform to the present trend.
Apart from MACD crossovers, traders also use divergences to make trading decisions. Divergence occurs when the MACD indicator forms highs and lows that diverge from the current highs and lows on the price.
Divergences are not as accurate as of the crossovers. By analyzing past data, it will be noticed that failed divergences cannot be found.
This is because as the price progressed, it no longer appeared as a divergence.
A bullish divergence occurs when the MACD forms two rising lows but the price forms two falling lows.
When the MACD forms a series of two falling highs that corresponds with two rising highs on the price, it is a bearish divergence.
Just like with MACD crossovers, divergences are more reliable when they conform to the present trend.
Always remember that trading trends are more reliable than trading reversals.
When to enter/ exit trades when using MACDs
As mentioned above, the histogram measures momentum. This should be used as an extra confirmation for trades and an indication to exit trades.
Momentum is a measure of price’s “willingness” to be either bullish or bearish. Therefore, this tool gives traders a visual representation of momentum.
When momentum is to the upside, the price takes less time to push upwards doing so with large candlesticks (buyers/ bulls are in total control).
In a bearish market, momentum is to the downside meaning sellers/ bears are in total control.
The MACD tick upwards when bullish momentum is present but ticks downwards when bearish momentum is present.
Furthermore, the length of the bars is a measure of the magnitude of momentum. We can use this to determine if it is safe to enter trades or not.
For example, in a bullish market:
From the image above, the bearish histogram bars reduced steadily.
The reduction of bars shows that sellers are slowly losing strength in the market. This thereby confirms an entry to be placed.
The trade will be held as long as the bars keep increasing. As soon as it starts reducing, the trade is closed.
In a bear’s market for instance:
Here, bearish momentum present confirms sell positions. Like in the previous example, positions will be held till the bars starts to reduce.
Summary; How to Trade with the MACD indicator in Forex
The moving average convergence divergence indicator should only be used for trending markets.
Ranging markets show that a stale mate between bull and bear is present at that time. Therefore, using the MACD during this type of market will only result to false signals.