MACD Indicator Explained

Definition of the MACD Indicator:

The Moving Average Convergence Divergence Indicator (MACD) is both a trend –seeking and momentum indicator which uses several exponential moving averages set to closing prices to generate trading signals. As we had earlier pointed out in one of our trading strategies, the Exponential moving averages use more of recent price data and therefore respond better to current market conditions than the simple moving averages.

The MACD indicator is a trend indicator. This function can be ascribed to its moving average components. The histogram bars of the MACD are a measure of the strength of the trend. Combining these factors allow the MACD to recognize tops and bottoms of trends and hence reversal areas.

MACD1

Components of the MACD Indicator

The MACD indicator consists of a Signal Line and a Differential Line. The Signal Line is simply a 9EMA (signal moving average) of the Differential Line values. The Differential Line is the difference between two exponential moving averages. These are by default, 12-period (short term) and the 26-period EMAs (long term). This is why the MACD indictor settings by default are 12, 26, 9.

MACD

Usage of Indicator
The MACD indicator can be used in the following ways:

  1. The MACD can be modified by the addition of a colour component to the histogram bars. This allows the indicator to recognize trend changes a lot earlier than the conventional indicator. The coloured MACD histograms have been used extensively in the “Forex Strategies” section of this site.
  2. The MACD can also be used as a component of trading strategies involving other indicators.

The MACD is hardly used alone for trade signalling. This is because it is a lagging indicator. It is best used as a component of trading strategies.

Indicator Settings

The indicator is listed on the MT4 as a momentum indicator. To attach it to the MT4 chart, click on Insert -> Indicators -> Oscillator -> MACD. The settings shown below are the default settings for the indicator.

In terms of appearance, some modifications to the look of the indicator can be made either by thickening the lines. The coloured version is a customized modification of the existing indicator. If you want a copy, write to the admin and it will be sent to you.

Usage of the MACD in Forex Trading

How is the MACD used in forex? The MACD indicator usually provides three different types of signals:

  1. The signal strength namely the strength of the trend. This is shown by the height of the histogram bars.
  2. The direction of the trend. The native MACD shows this when the bars cross from negative to positive and vice versa. If you are using a coloured MACD histogram, then the colour change will indicate a change in the direction of the trend.
  3. The second signal is the turning point of the price action. This is shown on the native MACD indicator as the cross of the signal line over the MACD bars. When the signal line crosses above the bars of the MACD, a sell-signal is given. When the signal line crosses below the MACD histogram bars, a buy-signal is generated. This has been used in one of the MACD strategies we have discussed earlier.

As discussed, the MACD is not used alone as a trade indicator. It must be combined with another indicator as part of a trading strategy. We have demonstrated several of them in the Forex Strategies section of this blog, including this one. But here is a simple illustration.

Long Trade Entry

A typical long trade setup is shown below. We have a combination of a signal from the Parabolic SAR indicator and the MACD. Here we combine some of the things we have identified with the MACD indicator.

  1. The MACD bars are above the signal line (see circled area)
  2. There has been a colour change to blue (which is bullish)
  3. On the same vertical plane, there is a bullish Parabolic SAR signal. This is a good place to buy the currency pair.

MACD_signals

b) Short Trade Entry
The short trade parameters are as follows:

  1. The MACD bars are below the signal line (circled area).
  2. The colour of the MACD indicator has changed to red (bearish signal).
  3. The Parabolic SAR indicator shows a bearish signal (dots above the candlesticks), on the same horizontal plane as (a) and (b). We therefore make the short trade entry as shown above.

Make sure you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management. We also ask you to refer to the Forex Strategies section to see how all these MACD signals have been deployed in forex strategies.

The MACD and its Buy and Sell Signals


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Video Transcript:

Hello traders. Welcome to the sixth module of the advanced technical analysis course, oscillators. In this lesson we’re going to teach you all about the MACD, how to use it to trade, and how to use it to spot momentum building in your price action charts. Remember that momentum is important for price to move in your direction quickly. This indicator will help you to spot the actual setups that will take price in your favor.

Let’s start by first defining the MACD. MACD stands for moving average convergence divergence and it’s a trending and momentum indicator. The indicator uses a MACD line, a signal line, and a histogram. A signal line is actually a moving average of the MACD line itself. Convergence occurs when the two lines move towards each other, and divergence occurs when they move away from each other.

MACD Explained

You will notice that the more divergence exists between the two lines, the higher the histogram is building. This means that when the divergence occurs we have momentum building. The histogram shows you the speed of the move or momentum. Like we said before, you will notice that you have a histogram building up or down when the two lines are farthest from each other. When the two lines start to move towards each other, the histogram starts to build down towards the zero line.

When the histogram starts to build above zero it, means that momentum is building to the up side. In this case, for example, you see that the histogram starts to build to the up side at the same time that this big blue candle starts to appear on your chart. This means that momentum is building to the up side. On this case, when this candle starts to appear to the down side, you can see that we have divergence from the two lines and we have momentum building to the down side, because the histogram is building below zero.

When the MACD line crosses the center line, we have shifted to an immediate bull market. In this case you can see that when the MACD line crosses below the zero line or the center line, we have switched to an immediate bull market. When it crosses back above it, we have switched to an immediate bull market. This is the overall look of the MACD. Now let’s go to see the actual setups that we will be looking for with this indicator. First of all for a bull setup.

We have to be clear on something. Unlike other oscillators, we are not looking for extreme readings. This means that we are not looking for the MACD to be above a certain level or below a certain level because the MACD does not show you overbought and oversold readings. It shows you the momentum in price. At a support zone, we look for the signal line to cross above the MACD line, this is what we call the MACD crossover.

We also need momentum to start building to the upside, meaning that once we have hit an area of support, we will be looking for a signal line to cross above the MACD line and the histogram to start building to the upside. Here’s an example. You can see that here we have come to a support level, and then we have a signal line crossing above the MACD line and we have momentum building to the upside.

Here we have a great opportunity to go long, and of course our stops should go always below the previous low. In this case, we have a winning trade and we can exit the trade when the signal line crosses below the MACD line and momentum starts building to the downside. As you can see here, by doing this we have caught the best of the move up. In a burst setup at a resistant level we look for a signal line to cross below the MACD line. The histogram will start building to the downside to know the move has enough momentum to take price down.

MACD Trading Setups

Here’s an example. Another Facebook chart, a 50 minute Facebook chart. You can see here that we have hit a big area of resistance and right here we have the signal line crossing below the MACD line and we have momentum building to the downside. We go short and here we can take out our position when this signal line crosses above the MACD line and momentum starts to fade and build to the upside.

As you can see, we have taken a nice dip on this one to the downside. The setups with the MACD are very easy to spot, but you need to use strong support and resistance areas as confirmation of the actual MACD crossover, and of course you need to always look at your histogram because if your setup doesn’t have enough momentum in it, price will not move in your favor and it will start to drop.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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