The moving average convergence divergence (MACD) is a popular indicator that can be used to confirm trend strength, direction, and momentum. Whereas other indicators are simply added to a price action chart, the MACD is charted on its own adjacent graph.
Like its name suggests, the MACD leverages a moving average variation called an exponential moving average, or EMA. As opposed to its close relative the simple moving average (SMA), the EMA is a weighted average that places greater mathematical significance on the most recent data point in a given set. Due to this difference, EMAs tend to be more sensitive to small market changes than SMAs (though greater sensitivity often comes at the price of greater volatility).
The MACD represents the difference between two seperate EMAs: a 26-day (slow) EMA and a 12-day (fast) EMA. In addition, a third, 9-day EMA is calculated using the derived MACD value and then superimposed onto the MACD chart to serve as a buy and sell signal line. When setting up an MACD, these three EMAs comprise the default settings of 12, 26, 9.
The length of the MACD histogram is indicative of price momentum, whereas the position of the histogram in relation to the signal line reveals the direction of the trend. As a rule, the histogram will elongate as price momentum accelerates and shorten as it decelerates. The MACD is considered positive when the histogram is above the EMA line and negative when it falls below the signal line.
Our histogram is comprised of bars rather than a single oscillating line, making it easier to see how the MACD moves above and below the zero axis. When the MACD is above this zero line, it means that the 12-day (short) EMA is greater than the 26-day (long) EMA and that momentum is moving upward. When the histogram is below zero and the bars are extending downward, the opposite is true.
Interpreting MACD Patterns
When trading with the MACD, there are three important patterns to look for: a crossover, a divergence, and a dramatic rise.
A crossover refers to an instance when the MACD traverses the signal line. Typically, when the MACD falls below the signal line, the trend is considered bearish, producing a sell signal. When it moves above the signal line, the trend is understood as bullish, suggesting that the trend is in the buyer’s favor.
As with other trend-following and trend-confirming tools, the MACD is apt to produce occasional false signals. To avoid getting “faked out” by small changes that aren’t indicative of greater trend changes, it’s best to confirm a crossover before entering into a position. Confirmation often means waiting for the trend to continue in the same direction or consulting other trend indicators to locate a similar, sustained pattern.
Trading divergence is perhaps the most popular way that the MACD is used in forex. A divergence refers to any instance where price reaches a new high or new low but momentum, as illustrated by the MACD histogram, does not reflect the same extreme. When price and momentum diverge, it typically indicates that the market is primed for a reversal.
Imagine that a trader is viewing the above divergence in real time, without the benefit of knowing what will occur in the right-hand quadrant of the graph. If the trader were to trade the divergence (i.e., anticipate that price would reverse following this new low), he or she would likely take a long position.
But there’s a problem with using the MACD as an all-knowing momentum indicator, and our earnest trader would ultimately exit the trade before the trend finally turned in his or her favor. Because EMAs are very sensitive to price movement, they can skew the accuracy of the MACD with regards to momentum signals.
However, in forex trading, the MACD is well suited for defining entry and exit points if the trader tweaks his or her strategy slightly. Instead of immediately going long and putting a stop at the nearest low, the trader would instead take a partial long position and exit the trade only if the new low exceeded its predecessor. If the next price candlestick failed to do so, as is the case with the graph above, the trader would instead average up and add to the position in hopes that he or she was still correct about the trend change. Though this strategy is not recommended for stocks trading, it works well in forex, where a larger position equates to larger gains in the event of a reversal.
Along with identifying points of divergence on your MACD histogram, another thing to keep in mind when trading divergence is the average direction of your price chart in relation to the histogram. If a divergence is truly occurring, the general directional trends of the charts should be opposite, as illustrated by the arrows below.
The MACD will rise dramatically when the short EMA is increasing faster than the long EMA, inevitably forcing them farther apart. This is thought to indicate that the market is overbought and that traders should look for sell opportunities. Remember that overbought conditions should be reflected on your price chart as an upward incline and can be confirmed using other overbought and oversold tools such as the relative strength index (RSI) and Stochastic Oscillators.
The Bottom Line
When using the MACD to trade divergence, understand trend direction, or gauge momentum, make sure to consult other trend-confirming tools and momentum indicators to ensure that you don’t act prematurely on false signals. The most lucrative forex trading strategies are those that take an informed approach, weighing and comparing insights from a variety of indicators in order to see the full picture. In the case of divergence trading, it’s better to average up on partial position than to take a full position and exit when the trend doesn’t immediately shift.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.