By: Richard Cox
One of the most common technical indicators that is used by day traders in the financial markets can be seen in the Moving Average Convergence Divergence -- more commonly referred to as the MACD. But one mistake that many new traders make is that they will simply start using this indicator without really understanding how it functions or makes its calculations. This can lead to costly mistakes that should have been completely avoidable. So, it makes sense to study the logic and calculations behind the MACD (and all other indicators) in order to more accurately configure your day trading positions and generate gains on a consistent basis.
The MACD Defined
Anyone with any experience in the forex markets and in technical analysis strategies has likely heard a great deal about the Moving Average Convergence Divergence (MACD). But what exactly does the MACD tell us -- and how is it calculated? Without an understanding of these areas, it can be difficult to see trading signals as they emerge. Here, will deconstruct the MACD indicator and explain how and why it is commonly used.
“In its most basic form,” said Haris Constantinou, markets analyst at TeleTrade, “the MACD is a momentum indicator that is designed to follow existing trends and find new ones.” The MACD does this by showing the differences and relationships between a two-level combination of moving averages and price activity itself.
To determine and calculate the MACD, we must subtract a 26 period Exponential Moving Average (EMA) from a 12 period EMA. Then, a 9 period EMA of the MACD is plotted, and this becomes the Signal Line for the indicator. The Signal Line is plotted over the MACD and this will be used as the trigger reading for trading signals (both buy signals and sell signals). These elements form the basis of the MACD construction, and it is important to have a strong understanding of these elements if you plan on using the indicator in your daily trading.
Three Common Approaches to the MACD
Now that we understand the basics of how the MACD is calculated, it is a good idea to look at some of the common ways that the MACD is viewed by traders so that we can get a sense of how exactly the indicator is used to identify trading opportunities. There are a few different ways the indicator can be interpreted, and the three of the most common methods proven to be the most effective for traders include Crossovers, Divergences, and in identifying Overbought / Oversold conditions
Since the indicator has become a major part of the technical trading community, it is a good idea to look at some of these approaches in greater depth. But before you can do this, it is essential you understand the basics. Failure to do this is what leads to a large number of losses for many traders that are just getting started.
The following are the three ways to interpret MACD:
When the MACD falls below the signal line, it represents a bearish signal for a forex contract. It gives an indication for traders to sell the currency pair or short it, as the case may be. On the other hand, if the MACD moves above the signal line (breaking it from below), then the market is supposed to be in an upward movement, representing a bullish trend as a result of which, many traders may either long a currency or hold position(s).
*Centre Line Crossover: This is another way to interpret MACD. When the MACD crosses over the central or zero line and moves from negative to positive, it suggests a sell signal for forex traders. On the other hand, when the MACD moves from positive to negative, it suggests a buying signal.
When the price of a currency pair deviates from the MACD, we can interpret it as the end of the current trend. Such a thing mainly occurs when the price of a share moves in one direction and MACD in another direction.
3. Overbought/Oversold Conditions
When the shorter term EMA moves above the longer term EMA, it suggests that the specific currency in question is in an overbought state- this implies that traders are likely to short the currency or square off their holdings.
MACD in Forex Trading
The Moving average convergence divergence (MACD) indicator was created by Gerald Appel in 1960. MACD is a momentum indicator and considered a valuable tool for any forex trader. MACD essentially indicates the correlation between the prices of two different moving averages of say two different forex contracts. It therefore shows the relationship between moving averages of two different prices.
MACD is calculated by subtracting the 26 day exponential moving average (EMA) from the 12 day exponential moving average (EMA). In addition, a 9 day exponential moving average is referred to as the signal line. The most commonly used EMAs for the MACD indicator are 12, 26 and 9 (suggesting the number of days for which the moving average is calculated). MACD can be applied to daily, weekly or monthly forex charts.
MACD = Short Term EMA - Long Term EMA
One of the main benefits of this indicator is that it can be used both as a trend and as a momentum indicator.
MACD can be a great way to quickly evaluate the market momentum and trend.
Day traders frequently use the MACD for predicting short term market trends.
The MACD indicator is not the most reliable indicator when the forex market is choppy.
Another serious drawback of the MACD is that it tends to be more descriptive than predictive- hence it is more suited to understanding the market trends rather than predicting it.
MACD is sometimes very difficult to interpret and use effectively, especially for novice forex traders.
The MACD is a very popular and commonly used in the forex technical analysis. It gives traders the ability to identify the direction of short term forex market trends and momentum quickly and easily. On the other hand, it does suffer from its drawbacks in that it is not always the most practical tool for predicting market movement, especially when the market is choppy.