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Trading Tools: Using the MACD Indicator to Trade Currency

   

macd-trading-tools

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.

As its name suggests, the MACD leverages a moving average variation called an exponential moving average (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.

Basics of the MACD

The MACD represents the difference between two separate EMAs: a 26-day (slow) EMA and a 12-day (fast) EMA. In addition, a third, nine-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, and 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 EMA (represented by the blue line) is greater than the 26-day EMA (the red line) and that momentum is moving upward. When the histogram is below zero and the bars are extending downward, the opposite is true.

Advantages of the MACD Indicator

Forex traders are drawn to MACD for a few different widely recognized benefits of this pattern. These benefits include:

  • Quick identification of short-term momentum. For day traders and other short-term traders, timing is everything. The faster you can pinpoint price momentum, the better your profit potential will be. Perhaps the biggest reason traders use MACD is to get on the leading edge of identifying patterns and opening positions before the momentum opportunity goes away.
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  • Ease of use. Compared to other indicators you might use, MACD is a straightforward tool that lends itself to quick, clear analysis. Beginning traders can incorporate MACD into their trading strategy with full confidence in their ability to interpret its insights.
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  • The ability to customize MACD’s timeline. While MACD defaults to 12-day and 26-day timelines, traders can customize the time frames used by this indicator to serve their specific trade analysis needs.

Disadvantages of the MACD Indicator

While the benefits of MACD may outweigh the drawbacks for many traders, there are still some potential disadvantages traders should be aware of. These include:

  • A high potential for false alarms. Even in cases where MACD correctly predicts a swing in price momentum, the sensitive nature of MACD can mean that traders may get caught in the fray of repeated buy and sell signals that aren’t followed by any significant change in price. While some traders may place more liberal stop-losses to account for this price movement, others may choose to be more careful with following MACD signals.
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  • Frequent false alarms could bleed your account of trading fees, eating away at MACD profits. If you lean on MACD too heavily to the exclusion of other indicators, you could end up buying and selling for small losses or minimal gains that rack up trading fees while denying you any meaningful profit. For short-term traders looking for quick profit opportunities, these small losses and charges can add up fast.

The biggest disadvantage of using this indicator to generate transaction signals is that a trader can get whipsawed in and out of a position several times before being able to capture a strong change in momentum. As you can see on the chart, the lagging aspect of this indicator can generate several transaction signals during a prolonged move, and this may cause the trader to realize several unimpressive gains or even small losses during the rally.

Interpretations of MACD Patterns

When trading with the MACD, there are three important patterns to look for: a crossover, a divergence, and a dramatic rise.

Crossover

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.

In the JPY/NZD chart below, these crossovers are identified any time the blue line and red line cross one another. This crossover is also represented by the histogram crossing its center line and switching from a downward orientation to an upward one, or vice versa:

Divergence

Trading divergence is perhaps the most popular way that the MACD is used in forex. A divergence refers to any instance where the price reaches a new high or new low but momentum, as illustrated by the MACD histogram, doesn’t reflect the same extreme. When price and momentum diverge, it typically indicates that the market is primed for a reversal.

In the GBP/NZD chart below, notice how the new low reached in mid-September isn’t reflected by a new low in momentum. What follows is a quick reversal in price movement that creates a profit opportunity for opportunistic traders.

 

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 regard 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 isn’t recommended for trading stocks, 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.

Dramatic Rise

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. 

In the CHF/USD chart below, a dramatic rise in short EMA creates a growing gap between the blue and red lines over the month of April. This is mirrored by an increase in price, which quickly leads to a swift decline in price that traders could avoid by seeking out a profit-taking opportunity during the tail end of that price rise.

 

 

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.

Combinations of MACD with Other Indicators

In most cases, it’s ill-advised to base forex trades off of a single indicator. To maximize the value of insights created through MACD, you should combine MACD with other trusted indicators to identify opportunities where MACD and other indicators are aligned in their price forecast.

Some of the best indicators to use in combination with MACD include:

  • Stochastic Oscillator: As an indicator that compares a currency pair’s closing price to its price range over time, a stochastic oscillator is a nice complement to the moving average-based trends identified through MACD.
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  • Relative Strength Index: RSI measures price changes for a currency pair in relation to highs and lows. This provides a different approach to evaluating momentum for a currency pair, which can help validate momentum indications offered by MACD.
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  • Bollinger Bands: Bollinger Bands are a reliable indicator to evaluate the cyclical volatility experienced by a forex currency pair. By accounting for historical volatility with the short-term momentum data offered by MACD, you can corroborate momentum identified through MACD and gain a more comprehensive view of potential price movements.
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  • The Value of Indicators_ MACD, RSI and the Stochastic Oscillator

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 a partial position than to take a full position and exit when the trend doesn’t immediately shift.

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Disclaimer:

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.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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