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.

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