MACD (moving average convergence divergence) is one of the most popular and widely used indicators in technical analysis for Forex trading (currency trading). In fact all the technical indicators described in are also used in Stock trading etc. ForexAbode.com being a site exclusively for Forex trading mention only the relevance of the technical indicators in Forex trading.
MACD is comprised of two EMA (Exponential Moving Averages) (please see the section “Moving Averages”). Two EMA means EMA for two time periods, one for longer period and one for shorter period. For example exponential moving average for past 12 periods and exponential moving average for past 26 periods.
MACD is a momentum Oscillator and can be used to know the momentum of the market in Forex Trading (currency trading).
MACD is unique in as it has lagging indicator elements as well as leading elements.
a) Moving averages are trend-following indicators as they tend to confirm the trend after it has begun and hence are classified as lagging indicators.
b) However, by taking the differences in the moving averages, MACD incorporates aspects of momentum or leading elements as it tells us in advance (with a slight lag) when a trend reversal may be taking place. We shall try to explain it in a simpler way as follows.
What MACD Tells Us:
MACD is a momentum* Oscillator. It tells us whether the momentum of the trend is increasing in an uptrend (bullish market) or downtrend (bearish market) or the momentum of the trend is slowing down. MACD may give many false signals when the market is running sideways, i.e. if there is neither an uptrend nor a downtrend for the currency pair, specially when the price movement range is narrow.
What is momentum
Rate of increase (acceleration) in currency pair'sprice movement during uptrend and Rate of decrease (acceleration) in price movement during downtrend.
Lets say we are driving a car:
Between 2:00 PM and 3:00 PM the average speed was 100 km/hr. Between 3:00 PM to 4:00 PM the average speed was 110 km/hr and during the next hour i.e. between 4:00 PM and 5:00 PM the speed was 111 km/hr.
Now the average speed is continuously increasing. We may get the illusion that it’s an uptrend as average is continuously getting higher. But its an illusion as we have not considered the momentum. If we notice the current average speed (between 4:00 PM to 5:00 PM), we would see that the momentum of increase in the average speed is dying down or getting reduced. The speed may further go down instead of going up, during the next hours.
Momentum takes out the illusion of the trend even if there is a constant upward or downward movement and tells us if the rate of change is slowing down or increasing. Slowing down of momentum may indicate a reversal of the trend in Forex trading..
Buying a currency pair is signaled when the uptrend is gaining momentum and selling of a currency pair is signaled when the downtrend starts gaining momentum.
Use of MACD in technical analysis in Forex (currency) Trading:
Suppose the market is bullish (uptrend) and the price of a currency pair is increasing. Before entering the long position (buy) we would like to know if the price increase rate (momentum) is maintained or it is slowing down. In case the price increase rate (momentum) is slowing down then the market might be going for a correction or reversal. That would mean that once we buy the prices may start falling down. The vice-versa is true in the downtrend (bearish) market. If the price decrease rate (momentum) is decreasing and we enter a short (sell) position, the downtrend may go for reversal and prices may start going higher instead of going down.
During an uptrend we would like to buy when we find out that the price increase rate i.e. momentu) is increasing. Because that tells us that the uptrend is increasing and the price of the currency pair may go higher.
Similarly in a downtrend we would like to enter the short (sell) position when we get the confirmation that the prices started falling down fast i.e. the price falling rate momentum has increased. Because that would indicated that the downtrend is gaining momentum and getting stronger i.e. the price of the currency pair may fall further and more.
So the objective is to know when the uptrend or downtrend momentum is increasing for the concerned currency pair in Forex trading..
Concept of MACD and how MACD is constructed:
The most common setting for MACD is 26, 12, 9. Now we will see what does it mean and how MACD is constructed.
Here “26” is EMA of previous 26 period, “12” is EMA of previous 12 periods. And MACD would be the line constructed by joining the points which we get by deducting EMA(26) from EMA(12).
i.e. MACD= shorter term moving average - longer term moving average.
In our case it means MACD = EMA for 12 periods – EMA of 26 periods.
Uptrend: If the EMA of previous 12 period (more recent data) is going over the EMA of 26 period (longer period data), it would indicate that in recent time the prices have started going higher.
Downtrend: If the EMA of previous 12 period (more recent data) is going under (lower) the EMA of 26 period (longer period data), it would indicate that in recent time the prices have started going down.
Now we have got the current MACD point by the above mentioned formula. And hence we have got a line connecting all MACD points of the past.
Now how do we find out the momentum? Please see Fig 2 below.
If we see Forex chart in figure 2 above we find that there is one more line which we may call as “MACD Signal Line”.
MACD Signal line is derived by taking the Exponential Moving Average (EMA) of the MACD line. Here with MACD (26,12, 9) we are taking the EMA of MACD for pervious 9 periods.
As now we know that if the recent Moving Average (short term moving average) is more than the longer term moving average, it indicates an uptrend as it shows that recently the prices are going up (hence the short term average is more than long term (past) average. But how do we find out the momentum of uptrend? We find the momentum by comparing if the positive difference today (or the current period) is more than the normal difference. So for this purpose we need to find out the normal difference. This normal difference is nothing but the “average” of the difference for past few periods. In our case (MACD 26,12, 9) it is the average of the differences over past 9 periods.
So what we are calculating is as follows.
1) Moving average of prices of the currency pair for past 12 periods, say “X”
2) Moving average of the prices of the currency pair for past 26 periods, say “Y”
3) Difference “X-Y” (MACD). If it is positive then it’s a signal for uptrend and if negative than of downtrend.
4) Moving average of “X-Y” for past 9 periods, say “Z”
5) If MACD line (connecting all “X-Y” points) crosses trigger line (line connecting all “Z” points, that would indicate that the current MACD is more than the MACD average for past 9 periods. This means that the difference (X-Y) is more than the normal difference. This indicates that the uptrend is increasing or gaining momentum. Time to buy.
Opposite of points 1 to 5 above would indicate the time to sell.
Summary of MACD Construction:
1. The MACD main line (sometimes called as MACD fast line) is calculated by taking the difference between two Exponential Moving Averages (EMAs) - popularly the 12 and 26 period EMAs.
2. The MACD signal line (sometimes called as MACD trigger line) is an EMA of the MACD main line. This popularly uses 9 period EMA of the MACD main line
3. THE MACD histogram is a bar chart that shows the difference between the two lines (main line and signal line) mathematically, it is the MACD signal line subtracted from the MACD main line (MACD Histogram =.MACD Main – MACD Signal)
4. We may also use shorter periods for shorter time frame trading. Shorter periods can also be used when market is very volatile.
How to Use MACD for technical analysis in Forex (currency) Trading:
The main signals you have to watch for:
1) MACD main line crossing MACD signal line.
2) MACD main line crossing the center line.
3) Divergence / Convergence
1) MACD main line crossing MACD signal line (trigger line).
When the MACD main line crosses the MACD signal line it gives a signal for change.
a) MACD main line moves from down to up: The recent upwards momentum is more than the normal. Uptrend is getting stronger (Forex chart in Fig 3):
A bullish moving average Crossover occurs when MACD moves above its 9-day EMA, or trigger (signal) line. This crossover above signals that the trend for the currency pair is becoming bullish (first currency of the pair getting stronger as compared to the second) and it’s the time to buy. This is probably the most common signal. Please keep in mind that MACD works better during a reversal of a trend (uptrend to downtrend or vice-versa) or during the sideways forex market when the price movement range is not very narrow for the concerned currency pair.
b) MACD main line moves from up to down: The recent downward momentum is more than the normal. Downtrend is getting stronger (Forex chart in Fig 3)
A bearish moving average Crossover occurs when MACD moves below its 9-day EMA, or trigger (signal) line. This is probably the most common signal. This crossover below signals that the trend for the currency pair is becoming bearish (first currency of the pair getting weaker as compared to the second) and it’s the time to sell. Please keep in mind that MACD works better during a reversal of a trend (uptrend to downtrend or vice-versa) or during the sideways forex market when the price movement range is not very narrow.
2) MACD main line crossing the center line.
a) A Bullish Center line Crossover occurs when the main MACD line moves above the zero/Center line. This gives a clear signal that momentum has reversed from negative to positive (from downtrend (bearish) to uptrend (bullish)).
b) A Bearish Center line Crossover occurs when the main MACD line moves below the zero/Center line. This gives a clear signal that momentum has reversed from positive to negative (from uptrend (bullish) to downtrend (bearish)).
Please take a note of the points A to F in the above Forex chart for EUR/USD (Fig 3):
Point A and associated area within the green circle:
The MACD main line moved over the MACD trigger (signal line). This gives a “buy” signal or the signal confirming an uptrend. The currency pair price continued moving upwards with minor corrections. At point “D” the MACD line moved below the MACD trigger (signal) line. This gives a signal that the uptrend may be ending and a downtrend may start. This was the time to sell the already bought lot for EUR/USD. In case we were not holding any bought position before this point “D”, we could short-sell the currency pair here to benefit from the possible downtrend.
Point B and associated area within the green circle:
At point “B” the MACD main line crossed over the “Center line”. This again signals that a bullish uptrend may continue for the currency pair.
Point D and associated area within the red circle:
At point “D” the MACD line moved below the MACD trigger (signal) line. This gives a signal that the uptrend may be ending for the currency pair and a downtrend may start. This was the time to sell the already bought lot. In case we were not holding any bought position before this point “D”, we could short-sell here to benefit from the possible downtrend.
Point E and associated area within the red circle:
The MACD line started crossing the MACD trigger (signal) line upward. This singled that the the prices may start going up (uptrend). This signal was not a strong signal as the MACD line did not really move up sharply.
Please take a note of areas within the circles of each points (as mentioned above). Before each crossover there has been a divergence. For example before the crossover at point D, the MACD line started moving downwards sharply (before the actual crossover). Similarly in the area of point “E”, the MACD line started moving upwards sharply before the actual crossover took place. In the area “C”, the MACD line started moving down but this move was not sharp. These sharp divergence may also indicate the possible change of the trend but these need to be taken care of cautiously.
Some of the above mentioned points would become more clear by continue reading this article.
3) Divergence and Convergence:
When the subsequent high or low points (peaks and valleys) in MACD line are going lower than the previous peaks. It may give a good signal for an emerging down trend. Similarly if the subsequent high and low points (peaks and valleys) in MACD line are going higher than the previous ones, it may give a good signal for an emerging uptrend.
MACD-Histogram was developed by Thomas Aspray in 1986.The objective was to reduce the lag.
Normal MACD gives us buying or selling signals as lagging indicator. Because of this lag sometimes important market moves are missed i.e. we may get the signal quite late. The objective behind the invention of MACD - Histograms was to speed up the signals i.e. to be able to anticipate the MACD crossover in advance.
The MACD-Histogram represents the difference between the MACD and its signal line (for ready reference in our example, the signal line or trigger line is the 9-day EMA of main MACD).
This difference between the MACD and its signal (trigger) line is presented as bars (please refer fig 6). This bar construction is called MACD-Histogram.
Histogram makes center line crossovers and divergences easily identifiable. If you see the figure 6 above, you would note that the Histogram makes a center line crossover whenever the MACD crosses the trigger line. In figure 6 the two yellow circles have been drawn as one example. You may please note that at other places also the Histogram crossing over the center line corresponds to the MACD crossing over the trigger line.
If the value of MACD is larger than the value of its 9-day EMA, then the value on the MACD-Histogram will be positive. Conversely, if the value of MACD is less than its 9-day EMA, then the value on the MACD-Histogram will be negative.
Further increases or decreases in the gap between MACD and its trigger line is reflected in the MACD-Histogram. Whenever the gap increases, the histogram bars becomes bigger and vice-versa hence bigger bars tell us that the momentum is increasing.
MACD-Histogram was designed to anticipate a moving average crossover in the MACD. This is achieved by looking at the Positive and Negative Divergences in the MACD-Histogram.
A Positive Divergence forms when the MACD-Histogram forms a higher Low and the MACD continued lower.
A Negative Divergence forms when the MACD-Histogram forms a lower High and the MACD continued higher.
Please see figure 7 to understand about this positive and negative divergences.
From point “X”, though the MACD continued going higher for some more time but the Histogram started going lower (Negative divergence). This signals that after the uptrend, a bearish move may come now and prices may start going down. The actual MACD crossover took place at point “Y”. Point “Y” would signal us about the downtrend and hence to “Sell” but Histogram indicated it earlier at point “X”.
Similarly, from point “P” though the MACD continued to go lower but the Histogram started going up (Positive divergence). This signals that a bullish move may come now and prices may start going up. The actual MACD crossover took place at point “Q”. Point “Q” would signal us about the uptrend and hence to “Buyl” but Histogram indicated it earlier at point “P”.
Divergences between MACD and the MACD-Histogram are the main tool used to anticipate moving average crossovers. A Positive Divergence in the MACD-Histogram indicates that the MACD is strengthening and could be on the verge of a Bullish Moving Average Crossover. A Negative Divergence in the MACD-Histogram indicates that the MACD is weakening and prices may start falling soon.
Notes:
The MACD-Histogram is an indicator of an indicator i.e. this was designed to indicate the movement of another indicator i.e. MACD. This may make it to give false signals more frequently as it is not “directly connected to the “price action”. MACD is connected to the “price action” and Histogram is connected with MACD. Because of this fact please avoid using MACD-Histogram in isolation and use it with the combination of other indicators to be able to filter out some of the false signals.
As with all other indicators, have two pictures, the broader picture e.g. weekly or daily chart and then the short term charts e.g. hourly charts. If the signal from longer-term forex chart and shorter-term charts are in synch (agree to each other) then the signals would have better probability of going true.
Also be careful of small and shallow divergences they may create false signals. One method to avoid small divergences is to look for larger divergences with two or more readily identifiable peaks or troughs. Compare the peaks and troughs from past action to determine its significance
Figure 8 below is for exercise. In this figure MACD, MACD-Histogram and price actions are there. Please take note of each point of change in reference to the explanation above. There is one point where MACD-Histogram signal was not effective even though it was correct. The meaning is that at other points the Histogram gave early signals to buy or sell and it could increase profit but at one point even though Histogram gave an early signal, the profit with that signal was less.
Well the figure 8 above is more for taking note of each point to have a better understanding of different movements (without explanations). As far as the question above is concerned, its point “A” (Histogram signal) and point “B” (MACD crossover signal). The Histogram signal was early for buying but it proved to be too early as the prices kept on going down instead of going up. At other points the Histogram signals were early and also resulted in higher profits…. But then, who says that the world is perfect
We explained MACD (Moving Average Convergence/Divergence) in the context of Forex Trading but the same stands good for stock trading or any commodity trading.
