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4.30 Trading with MACD Indicator
We had looked earlier at moving averages and their exponential kind (EMA). In our relentless zeal to arm you with every kind of weapon to take on the Forex markets, we are now going to tweak the EMA a bit, and modify it into a new indicator called the Moving Average Convergence Divergence. That’s a mouthful, so we’ll stick with its acronym, the MACD.
The Moving Average Convergence Divergence (or, MACD) is basically the difference between a fast exponential moving average and a slower exponential moving average. It gets this name because the fast exponential moving average is always converging toward or diverging away from the slower exponential moving average. Hence MACD is calculated using the following formula:
MACD = (Shorter term moving average) – (Longer term moving average).
The most common EMA’s used for MACD are of 12 periods and 26 periods.
A third, dotted exponential moving average of the MACD (the “trigger” or the signal line) is plotted on top of the MACD. The Signal line is derived by taking the Exponential Moving Average (EMA) of the MACD i.e. the difference between the faster and slower EMAs. The most common period to calculate the signal line is 9 periods and hence the signal line is the exponential moving average of the differences of past 9 periods.
To summarize, With MACD (12,26,9) what we are calculating is as follows:
- Moving average of past 12 periods, say “X”
- Moving average of past 26 periods, say “Y”
- Difference of the above two i.e. “X-Y”. The line joining the numbers of these differences becomes the main MACD line.
- Exponential moving average of “X-Y” for past 9 periods, say “Z”. The line joining these points becomes the signal line.
- If MACD line remains above the trigger or signal line then indicates bullishness and if it remains below then it indicates a bearish market.
You will see a third component when you plot MACD on your trading chart and this is called MACD Histogram.
The MACD Histogram (the spiky bars around the zero line) represents the difference between MACD and its 9-day EMA, the Signal line. The histogram is positive when the MACD Line is above its Signal line and negative when the MACD Line is below its Signal line. All will be clear when you see the chart here.
The MACD captures both momentum and trend-following aspects relating to the market. This is because moving averages are inherently trend-following, and when we look at their crossovers, i.e. when a shorter-term moving average crosses over a longer term moving average, or vice versa, we get clues to increasing (or decreasing) momentum.
The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, the MACD offers the best of both worlds: trend following and momentum.
Now that you have a clue about the MACD’s internals, let’s see the recap of its construction and calculation steps:
- 26-day EMA
- 12-day EMA
- MACD Line: (12-day EMA minus 26-day EMA)
- Signal (or Trigger Line): 9-day EMA of MACD Line
- MACD Histogram: MACD Line minus Signal Line
Before you utterly and completely panic, let us tell you that you don’t need to calculate the stuff above – most charting packages are programmed to do it. You just have to set the parameters fields and the package does the rest!
Why MACD with period settings of 12, 26 and 9?
Traders used to us technical indicators even when there were either no charting software. In those old days of manual charting or working with not so powerful charting software, one could not draw a chart every minute and hence daily opening & closing prices and daily price action had to be important criteria for analysis. Considering all the period settings for any technical indicators, including MACD, are based on working days. Please note that in those days a working week consists of 6 days and not 5 days. The period setting for MACD represents the following:
- 12 for two trading weeks.
- 26 for one trading month.
- 9 for one and a half trading week.
In the modern times when we have a 5-day trading week with Saturdays and Sundays off. Considering this we can always argue about changing the period settings to “10, 22, 7” or “10, 22, 8”. The trading platforms offer only whole numbers settings and hence we cannot have 7.5 as one and a half weeks. Well the argument is justifiable but read on to see why sticking with the original settings makes more sense.
Rationale behind using old period settings
A Technical indicator is not a magic. Technical analysis works only because traders tend to make their trading decisions based on the signals generated common indicators. If MACD produces a bullish signal and lot of traders start buying because of that, the price will rise further because of the demand generated. Same goes for selling. This fact goes in favor of using a period setting which is more commonly used world-over. The standard period setting of MACD considering a trading week of 6 days has been in use for many decades and hence even today this setting is used most commonly.
You may come up with another question that when the period setting is based on days then why do we use the same settings on hourly charts or any other time-frame charts. The answer is again same that technical indicators work mainly if a lot of buying and selling takes place because of the generated signals. Whatever is the time frame of charts, traders tend to use the same settings and hence you should too.
How to trade using the MACD
Now that all the boring stuff is out of the way let’s get with the meaty stuff and how you can use MACD to pluck a few pips from the Forex money machine!
There are three ways to use the MACD in trading – using the signal line crossovers, the centerline (the ‘zero’ line) crossovers, and divergences. The first is the most commonly used signal, and in our zeal to keep things simple (and our typing less!) we’ll use it and pretend not to have heard about the others.
Whenever a price shift occurs, the MACD line (the moving average of the difference between 12- and 26-period moving averages) is faster to respond compared to the signal line (the moving average of the MACD line), and will cross through it, and then gradually move away (‘diverge’) from it. This is the signal that a new trend is under way.
- A bullish crossover occurs when the MACD turns up and crosses above the signal line.
- A bearish crossover occurs when the MACD turns down and crosses below the signal line.
So, buy if the crossover is bullish, and sell if it is bearish. Simple!
Just one point – it’s may be better to use the MACD in conjunction with another suitable indicator to check on the strength of trends. With the Forex market you can’t be too careful.
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4.31 Trading with MACD Histogram Divergences
MACD Histogram was developed by Thomas Aspray in 1986 for reducing the time lag of the MACD crossover signals.
As we have seen, 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.
The difference between the MACD and its signal line is presented as bars. Please refer the following illustration. This “bar construction” is called MACD Histogram. You will note that after a crossover, when the gap between the MACD line and it’s signal line widen ups, we get longer bars. These start becoming shorter when the gap reduces. The green bars come into the picture when price starts rising and the red ones when the price drops.
The histogram bars start showing bullish (positive) or bearish (negative) divergences well before the actual crossover and hence indicate in advance about the possibility of a reversal.
MACD generates buying or selling signals primarily as a lagging indicator even though it has some characteristics of a momentum indicator as well. This time lag may result in missing some important market moves. Because of the lagging characteristics, at times, we may get the signal quite late and hence may miss the opportunity to take the trading decision at the right time. The divergences in MACD Histogram help in speeding up the signals by enabling us to anticipate the MACD crossover in advance.
Before we go ahead, let’s check what are the divergences.
Histogram with Bearish Divergence
A bearish divergence is nothing but a situation when the price-action continues to show bullishness by moving up while the technical indicator, in this case our MACD histogram, starts showing bearish signs. In simple words a bearish divergence is a divergence from the bullishness of the price-action. Bearish divergence is also termed as negative divergence. Lets have a look on the following chart to have a visual explanation:
If you see the above chart, it is clear that if you would have taken a short-selling position when the histogram started having a bearish divergence, you would have gained more pips than waiting for bearish crossover of MACD as a signal.
A word of caution here – entering into a trade is not advisable as soon as you see the initial signs of a divergence. It is better to wait for at least 4 to 5 histogram bars for confirmation.
Histogram with Bullish Divergence
A bullish divergence comes into the picture when the price-action continues to show bearishness by falling further while the technical indicator, in this case our MACD histogram, starts diverging and starts getting bullish. Bullish divergence is also termed as positive divergence at times. Check up the following chart to have a visual explanation:
The above MACD histogram chart is a good example of bullish divergence. As you can see that the bullish crossover of MACD took place long after the histogram started diverging from the price-action. However in this case a trade based on the divergence might have met the stop-loss as the actual reversal took place with the crossover. The reason is simple that the price action was choppy before that. But then, no technical indicator is always a sure shot, right?
Let’s see one more example of MACD histogram with bullish divergence:
In the above Forex chart a position based on the divergence of the Histogram would have earned a few more pips as the reversal took place well before the MACD crossover.
Histogram makes center line crossovers and divergences easily identifiable. If you look at the above Forex charts, you would note that the Histogram makes a center line crossover, whenever the MACD crosses the trigger line.
The MACD Histogram is an indicator of an indicator because this was designed to predict the movement of another indicator i.e. MACD. This may lead it to generate false signals more often as it is not “directly” connected to the “price action”. MACD is connected to the “price action” and Histogram is connected to the MACD. Hence please avoid using MACD Histogram in isolation. Either use it as an early warning system with the MACD or use it on longer time frame charts like daily chart. On short-term charts you may come across the false signals quite frequently. Another word of advice would be to have wider stop-loss levels for any positions based on histogram divergences. After all you are expecting gains of more pips, right?