[dropcap]T[/dropcap]he MACD (typically read as “mac D”) is one of the most popular indicators among forex traders. It’s a very useful tool in your trading arsenal. And it’s helpful even if you aren’t using it as your main signal generator!
One of the reasons it’s so popular is that it’s a very versatile trading indicator, despite being relatively simple in construction. This allows it to have multiple and varied applications which help forex traders develop their own style when using it.
Because of its versatility, you could probably write a whole book on how to squeeze the last drops of utility out of it. So, let’s focus on the basics to get a good understanding of how the MACD’s gears synch. And, from there, you can customize it to your preference.
The Converging Divergence
The MACD combines one of the most effective and popular forex trading styles; divergence, with crossovers. This allows it to generate a wealth of signals to suit most FX trading styles. It even allows it to “check” itself in providing parallel analysis points.
The name comes from Moving Average Convergence Divergence. It works based on two exponential moving averages, a fast and a slower one. The difference between those is then represented in the “histogram” (the solid bars). The slower EMA is graphed on top of the histogram, providing the signals (and thus is often called the “signal line”).
The Theory
By playing two exponential moving averages off each other, the MACD is looking to identify a forex market trend, and then find when it’s becoming exhausted. This allows for the “crossover” function of the signals. By definition, before the market can go in a new direction, it has to cross over the prior trend.
The MACD offers a level of sophistication to this basic principle by plotting the difference between the slow and fast EMA, showing the momentum of the market. Signals are produced when the momentum crosses through the trendline, not just when the EMA does. You see this on the chart when the trend in histogram bars cross underneath the signal line.
The Practice
Because the idea is to catch changes in trend, generally you’d say a signal was produced when the histogram crosses the signal line in the direction towards the centerline (0 on the chart). Why? Well, because the histogram measures the difference between the long and short term trend. If the long trend is changing direction, then the difference between it and the short term trend will shrink until they are running parallel. Then the trend changes.
This means that the bigger the histogram bars, the further the short term trend has drifted from the long term one. And the more likely the market is to reverse to the mean. This is why it’s popular among swing forex traders, as well. The deviation of the histogram from the signal line can show the market becoming oversold or overbought.
Divergences
By generating a histogram, the MACD can also be used quite effectively to show market divergences as well. This happens as the market trends in one direction, but the histogram moves in the other. At the end of the divergence, you’ll expect to have a market reversal, the favorite position for most forex traders.
Why this happens is that the longer a trend exists, the more likely it is to get exhausted. This presents as smaller movements in the short term trend, and that allows the long term trend to catch up. The histogram bars become shorter, indicating market exhaustion. Eventually, the counter move will push the histogram to cross the signal line, showing you have an opportunity to get into the market.
The Caveats
No indicator is perfect and complete. While the MACD is very useful and versatile, it’s always better to trade an indicator in conjunction with another to verify signals. And always keep an eye on the price action to set your safeties properly.
Hopefully now that you know why the signals are produced by the MACD, you can have a better understanding of strategy development using this neat indicator.
