Using the MACD indicator in forex trading
The moving average convergence/divergence indicator (MACD) is one of the best solutions to use when working in the financial markets. Learning how to implement the tool is crucial to a trader's success. We will examine three common MACD strategies.
What is the MACD?
This tool is one of the most commonly used in technical analysis. It is an impulse indicator that tracks the trend. That is, it determines whether the trend is upward or downward. Therefore, it can be used to provide trading signals and identify trading opportunities.
How does the MACD work?
The MACD uses three components in its work: two moving averages and a histogram. The two lines may look like ordinary moving averages (SMAs) but are in fact multi-level exponential moving averages (EMAs). The basic, slower line is the MACD line, while the faster line is the signal line.
If two moving averages converge, they are said to be "converging", and if they move away from each other, they are "diverging". The difference between the two lines is represented on the histogram. If the MACD was trading above the nought line it would confirm an uptrend, below it the indicator would be used to confirm a downtrend.
If the market price was found to be on an upward trend, making higher highs and lower lows, and breaking through key resistance levels - traders can open long positions. While traders can choose to go short if the asset is in a downtrend, which is characterised by lower highs as well as lower lows or breaks support levels.
Three common MACD trading strategies
There are a number of MACD strategies that can be used to find opportunities in the markets. Three of the most popular strategies include:
- Histogram reversal
- Zero crosses
The MACD line together with the signal line can be used in much the same way as a stochastic oscillator, with the crossover between the two lines providing buy and sell signals. As with most strategies, a buy signal is given when the shorter, more reactive line - in this case, the MACD line - crosses the slower signal line. Conversely, when the MACD line crosses below the signal line, it gives a bearish sell signal.
Because the crossover strategy is lagging in nature, it is based on waiting for movement before opening a position. The main problem the MACD has with weak market trends is that by the time the signal is generated, the price may have reached a reversal point. This would be considered as a "false signal". It is worth noting that strategies that use price action to confirm the signal are often seen as more reliable.
The histogram is probably the most useful part, and the bars represent the difference between the MACD and the signal lines. When the market price is moving strongly in the direction, the histogram will increase in height, and when the histogram is contracting, it is a sign that the market is moving more slowly.
This means that as the bars of the histogram move further away from zero, the two moving average lines move further away from each other. Once the initial expansion phase is over, a hump shape is likely to emerge - a signal that the moving averages are contracting again, which could be an early sign of an impending crossover.
This is the leading strategy, unlike the lagging crossover strategy mentioned above. The reversal is based on the use of known trends as a basis for positioning, which means that the strategy can be executed before the market movement actually occurs.
The zero-cross strategy is based on either EMA crossing the zero line. If the MACD crosses the zero line from below, a new uptrend may occur, while a MACD cross from above is a signal that a new downtrend may start.
This is often seen as the slowest signal of the three, so you will generally see fewer signals, but also fewer false reversals. The strategy is to buy - or close short - when the MACD crosses the zero line from below, and sell - or close long - when the MACD crosses the zero line from above.
This method should be used with caution because its delayed nature means that fast, volatile markets will often generate signals released too late. However, as a solution to provide reversal signals for long wide moves, it can be very useful. When using a zero-crossing strategy, it is important to understand where to exit the market or make a stop.
When is the best time to use the MACD?
There is no such thing as the 'best' time to use the indicator, it will depend entirely on you, your personal preferences and trading plan. For some, there may not be a right time to apply it, as they do not take a technical approach to analysis or prefer to use many other indicators to identify price action.
However, if you decide to use MACD, the best timing will depend on which of the above strategies you want to use. If you choose a lagging strategy, you will have to keep a close eye on the MACD in order to get signals as quickly as possible. But if you choose a leading strategy such as the bar chart, you could spend less time monitoring, as the signals should appear earlier.