What is the MACD Indicator?
The Moving Average Convergence Divergence (MACD) indicator helps traders quickly identify short term trend directions and reversals in the forex markets. You can use the MACD indicator to determine a currency pair price trend’s severity and measure its price’s momentum and even identify the bearish and bullish movements in the currency pair prices. In this article, we discuss everything you need to know about the MACD indicator and how you can make the most of it.
Understanding the MACD indicator
The Moving Average Convergence Divergence indicator depicts the relationship between two different moving averages of a currency pair’s price. It helps in analysing the currency pair’s price strength, weakness, direction and momentum in the forex market. The MACD indicator identifies the highest upward and lowest downward trends. With the highest upward trend, the ideal exit point can be identified and with the lowest downward trend, we can get the ideal entry point in the forex market.
How to read MACD indicator
The Moving Average Convergence Divergence (MACD) graph is represented right below the currency pair’s price chart so that each price movement can be easily compared with the movement in the MACD chart. Whenever the histogram is a positive sign, implying that it is above the baseline, it means that the MACD value is greater than its previous nine-day average, and there has been an incline in the uptrend. At this point, you can place long orders. However, when the MACD value is lower than its previous nine-day average and the histogram is below its baseline, it indicates that there has been a decline in the market momentum. This signals you to place short orders. Any peak in the histogram indicates a bearish momentum losing strength, and a trough represents a bullish momentum losing strength and results in a trend reversal. In the graph, the letter ‘T’ represents when there is a peak (or top) in the market. On the other hand, the letter ‘B’ represents when there is a trough (or bottom) in the market. The MACD graph shows either a convergence in the currency pair price momentum or a divergence. A convergence is identified when the MACD histogram shrinks due to a decline in the currency pair prices. A divergence is identified when the MACD histogram starts increasing in height due to an incline in the currency pair prices.
How to calculate MACD?
1. Calculate the simple moving average (SMA) for the time period you are considering. The SMA will help you determine the exponential moving average (EMA). 2. Calculate the weighted multiplier, also called smoothening, that will be used to calculate the MACD indicator through the given formula. Smoothening = 2/(number of period+1) 3. Now, the EMA will be calculated for the number of periods considered by taking SMA as the first EMA or the previous day's EMA, followed by other EMAs. It will then be divided by the number of periods. EMA = currency pair closing price * smoothening + EMA of the previous day (also called the SMA calculated above) * (1-smoothening) To calculate the MACD indicator value, you will be determining a 12 period EMA (short-term moving average), 26 period EMA (long-term moving average) and a nine period EMA (signal line). 4. The MACD indicator is calculated by subtracting the two exponential moving averages (EMA) belonging to the 26-period and 12-period. Hence, MACD indicator calculation formula = 12 period EMA – 26 period EMA, where EMA = [currency pair price value today * (smoothing/1+days)] + EMA of yesterday * [1– (smoothing/1+days)]
How is MACD calculated and how does it work?
The MACD indicator is calculated by subtracting the two exponential moving averages (EMA) belonging to the 26-period and 12-period. Hence, MACD indicator calculation formula = 12 period EMA – 26 period EMA, where EMA = [currency pair price value today * (smoothing/1+days)] + EMA of yesterday * [1 – (smoothing/1+days)] And smoothing = weight provided for the EMA calculation, generally assumed as 2. When the difference between the two exponential moving averages is found, it is referred to as the MACD line. Another 9-period EMA of the same MACD is called the signal line, which can be plotted on top of the MACD line.
- You can buy more of the currency pairs when the MACD line crosses the signal line from above. This is also called a bearish signal.
- You can sell more of the currency pairs when the MACD line crosses the signal line from below. This is also called a bullish signal.
The difference between the 12-day EMA and 26-day EMA is graphically plotted on the MACD histogram. It also consists of a zero line, which is a centerline dividing the positive chart area and the negative chart area. Bearish and bullish momentum in the forex market can be identified by the MACD line’s movement above and below this line.
Trading the MACD divergence
Divergences with MACD can be traded by identifying the currency pair price swing highs and lows, but no highs or lows in the MACD histogram. This creates a divergence between the currency pair price and momentum, allowing traders to trade with MACD. Here are four easy steps in which you can trade divergences with the MACD indicator –
1. Identify the existing trend’s direction
You can use the moving averages to identify the existing direction of the trend. If the current trend direction is in an uptrend, you can place long orders, and if the current direction of the trend is downwards, you can place a short order.
2. Confirm the trend signal through the MACD histogram
The existing trend signal can be confirmed by looking at the MACD signals. If the histogram is above the baseline during an uptrend, it means that the uptrend is confirmed. If it is below the baseline during a downtrend, it means that the downtrend is confirmed. If the current trend and the histogram value do not align, it sends a trend reversal signal.
3. Use the MACD crossover to place orders in the trend’s direction
After identifying the confirmed current trend, you can look for ideal entry signals to trade along with the direction of the trend. The MACD crossover provides ideal entry signals when the currency pair price is above the moving average. The MACD line must also be above the signal or red line in order to place a successful entry order.
4. Use the MACD’S zero line for risk management
In order to protect yourself from trading risks, use the MACD indicator’s zero line to exit a trend before it ends. During an uptrend, if a bearish crossover occurs where the moving average line crosses the MACD line from above, you can exit your long position at this point. However, during a downtrend, if a bullish crossover occurs where the moving average line crosses the MACD line from below, you can exit your short position and place a long order.
How to use the MACD indicator for entry and exit signals
The MACD indicator provides strong entry signals when the MACD line crosses the signal line in the same direction as the existing trend. If the MACD line crosses the signal line from above, it sends bullish signals and provides traders with a long entry position by confirming an uptrend. However, if the MACD line crosses the signal line from below, it sends bearish signals and provides traders with a short entry position by confirming a downtrend.
You also receive exit signals with the MACD indicator. If the MACD histogram shows a new swing high, it sends you a signal to exit their short entry positions due to an expected uptrend. However, if you have opened a long position and the MACD histogram shows that there has recently been a new swing low, it signals you to exit the long trade position due to an expected downtrend.
Top MACD trading strategies
A crossover is a point in the chart where the currency pair prices and the indicator intersect. Crossovers help in estimating the currency pair’s performance in the forex market and forecasting future prices as well as trends. You can use the MACD indicator to identify entry points in the market when it crosses the slower line, also called the signal line from above. The crossover strategy is one of the most common MACD trading strategies, and it can be used by beginner traders easily, as well. Profitable entry points are always identified at the crossover, highlighted as vertical green lines in the picture below. However, when trading with the MACD indicator, you must be aware of the false signals as well, highlighted in red. The best way to avoid any false signals is to wait for a price movement to occur before you take any decision, but not keep waiting for too long. If you wait for too long after the price movement occurs, the currency pair price could reach its reversal point and send you a false buying signal.
The MACD histogram increases in height during a strong market direction and shrinks in height during a slow market movement. The histogram reversal trading strategy can help you place successful trades even before the actual market movement takes place. When two counter-trend moves (first an upward trend, then a downward trend or vice versa) occur in the histogram, it ensures that there is going to be a trend reversal. If you place your trades in the direction of the market, you can earn significant profits. This is because once the price goes through a counter-trend, it remains in the same trend for a while. This situation can be used in your favour by either moving along with the trend or exiting the market at the right time to mitigate losses.
- If you see the price movement of a currency pair in the MACD histogram first increasing and then decreasing, it sends you an exit signal in the market to protect you against losses.
- If you see the price movement of a currency pair in the MACD histogram first decreasing and then increasing, it sends you an entry signal in the market to maximise your profits.
The zero-cross trading strategy with the MACD histogram refers to either of the two exponential moving averages crossing the zero line at some point in time. Whenever the MACD line crosses the zero line from above, it is an uptrend that sends you buy signals. Whenever the MACD line crosses the zero line from below, it is a downtrend that sends you to sell signals. In this particular strategy, you also see several trendline breaks, which signals you to exit the trade immediately if you want to minimise your losses.
- You can use a break below the last swing low during an uptrend to exit a trade.
- You can use a break above the last swing high during a downtrend to exit the trade.
Trade with the MACD indicator to identify favourable trend reversals
Trading with the MACD indicator helps you detect any change in the currency pair price’s fluctuation in the stock market. It enables you to identify the right entry and exit points to make profitable trades. Since it is based on historical data, it can also be used to predict trend changes and take further positions accordingly. With our platform, you can combine the MACD indicator with several other indicators to make sure that you always place successful trades. Sign up for a live account today or try a risk-free demo account.
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