Forex Trading - Moving Average Convergence Divergence

Moving Average Convergence Divergence – MACD

MACD, which stands for Moving Average Convergence Divergence, is a trend-following momentum indicator that shows the relationship between two moving averages of prices. Developed by Gerald Appel, MACD is one of the simplest and most reliable indicators available. This tool is used to identify moving average which indicate a new trend, regardless of whether it is bullish or bearish. After all, the most important priority in trading is to find a trend, because the most money revolves around it.



With MACD chart, you'll usually see three numbers that are used to configure it:
1. First is the number of periods that is used to calculate the faster moving average
2. Second is the number of periods that is used to calculate the slower moving average
3. Third is the number of candles that are used to calculate the moving average of the difference between faster and slower moving average

The lines on MACD charts are often misunderstood, two lines that are drawn are not the moving average of prices. They are the moving average of the difference between the two moving average.

In our example, the faster moving average is the moving average of the difference between 12 and 26 periods of moving average. Slower moving average outlines a previous average of MACD lines. We calculate the average of the last 9 periods of faster MACD line, and outline it as a slower moving average. This moderates the original lines, giving us a more accurate chart.

Histogram outlines the difference between faster and slower moving average. If you look at the above chart you will see that when the two moving averages separate, histogram becomes greater. This is called divergence, because the faster moving average is diverging from the slower moving average.

When the moving average lines come closer together, histogram becomes smaller. This is called convergence, because faster moving average is converging, coming closer to slower moving average. This is why this indicator is called the Moving Average Convergence Divergence.

MACD Formula

The most popular formula for the "standard" MACD is the difference between 26-day and 12-day Exponential Moving Averages (EMAs). This is the formula that is used in many popular technical analysis programs and quoted in most technical analysis books. Using shorter moving averages will produce a quicker, more responsive indicator, while using longer moving averages will produce a slower indicator, less prone to whipsaws.

Of the two moving averages that make up MACD, the 12-day EMA is the faster and the 26-day EMA is the slower. Closing prices are used to form the moving averages. Usually, a 9-day EMA of MACD is plotted along side to act as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA, and a bearish crossover occurs when MACD moves below its 9-day EMA. The histogram represents the difference between MACD and its 9-day EMA. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.

MACD Bullish Signals

MACD generates bullish signals from three main sources:
1. Positive Divergence
2. Bullish Moving Average Crossover
3. Bullish Centerline Crossover

Positive Divergence

A Positive Divergence occurs when MACD begins to advance and the currency is still in a downtrend and makes a lower reaction low. MACD can either form as a series of higher Lows or a second Low that is higher than the previous Low. Positive Divergences are probably the least common of the three signals, but are usually the most reliable, and lead to the biggest moves.

Bullish Moving Average Crossover

A Bullish Moving Average Crossover occurs when MACD moves above its 9-day EMA, or trigger line. Bullish Moving Average Crossovers are probably the most common signals and as such are the least reliable. If not used in conjunction with other technical analysis tools, these crossovers can lead to whipsaws and many false signals. Bullish Moving Average Crossovers are used occasionally to confirm a positive divergence. A positive divergence can be considered valid when a Bullish Moving Average Crossover occurs after the MACD Line makes its second "higher Low".
Sometimes it is prudent to apply a price filter to the Bullish Moving Average Crossover to ensure that it will hold. An example of a price filter would be to buy if MACD breaks above the 9-day EMA and remains above for three days. The buy signal would then commence at the end of the third day.

Bullish Centerline Crossover

A Bullish Centerline Crossover occurs when MACD moves above the zero line and into positive territory. This is a clear indication that momentum has changed from negative to positive, or from bearish to bullish. After a Positive Divergence and Bullish Centerline Crossover, the Bullish Centerline Crossover can act as a confirmation signal. Of the three signals, moving average crossover are probably the second most common signals.

Bearish Signals

MACD generates bearish signals from three main sources. These signals are mirror reflections of the bullish signals:
1. Negative Divergence
2. Bearish Moving Average Crossover
3. Bearish Centerline Crossover

Negative Divergence

A Negative Divergence forms when the currency advances or moves sideways, and the MACD declines. The Negative Divergence in MACD can take the form of either a lower High or a straight decline. Negative Divergences are probably the least common of the three signals, but are usually the most reliable, and can warn of an impending peak.

Thee are two possible means of confirming a Negative Divergence. First, the indicator can form a lower Low. This is traditional peak-and-trough analysis applied to an indicator. With the lower High and subsequent lower Low, the uptrend for MACD has changed from bullish to bearish. Second, a Bearish Moving Average Crossover (which is explained below) can act to confirm a negative divergence. As long as MACD is trading above its 9-day EMA, or trigger line, it has not turned down and the lower High is difficult to confirm. When MACD breaks below its 9-day EMA, it signals that the short-term trend for the indicator is weakening, and a possible interim peak has formed.

Bearish Moving Average Crossover

The most common signal for MACD is the moving average crossover. A Bearish Moving Average Crossover occurs when MACD declines below its 9-day EMA. Not only are these signals the most common, but they also produce the most false signals. As such, moving average crossovers should be confirmed with other signals to avoid whipsaws and false readings.

Sometimes a currency can be in a strong uptrend, and MACD will remain above its trigger line for a sustained period of time. In this case, it is unlikely that a Negative Divergence will develop and a different signal is needed to identify a potential change in momentum.

Bearish Centerline Crossover

A Bearish Centerline Crossover occurs when MACD moves below zero and into negative territory. This is a clear indication that momentum has changed from positive to negative, or from bullish to bearish. The centerline crossover can act as an independent signal, or confirm a prior signal such as a moving average crossover or negative divergence. Once MACD crosses into negative territory, momentum, at least for the short term, has turned bearish.

The significance of the centerline crossover will depend on the previous movements of MACD as well. If MACD is positive for many weeks, begins to trend down, and then crosses into negative territory, it would be bearish. However, if MACD has been negative for a few months, breaks above zero, and then back below, it might be a correction. In order to judge the significance of a centerline crossover, traditional technical analysis can be applied to see if there has been a change in trend, higher High or lower Low.

Using a Combination of Signals

Even though some traders may use only one of the above signals to form a buy or a sell signal, using a combination can generate more robust signals which will increase your chances of catching a trend and generating a profit.



MACD-Histogram

In 1986, Thomas Aspray developed the MACD-Histogram. Some of his findings were presented in a series of articles for Technical Analysis of Stocks and Commodities. Aspray noted that MACD's lag would sometimes miss important moves, especially when applied to weekly charts. He first experimented by changing the moving averages and found that shorter moving averages did indeed speed up the signals. However, he was looking for a means to anticipate MACD crossovers. One of the answers he came up with was the MACD-Histogram.



Definition and Construction

The MACD-Histogram represents the difference between the MACD and its trigger line, the 9-day EMA of MACD. The plot of this difference is presented as a histogram, making centerline crossovers and divergences easily identifiable. A centerline crossover for the MACD-Histogram is the same as a moving average crossover for MACD. If you will recall, a moving average crossover occurs when MACD moves above or below the trigger line.

If the value of MACD is larger than the value of its 9-day EMA, then the value on the MACD-Histogram will be positive. Conversely, if the value of MACD is less than its 9-day EMA, then the value on the MACD-Histogram will be negative.

Further increases or decreases in the gap between MACD and its trigger line will be reflected in the MACD-Histogram. Sharp increases in the MACD-Histogram indicate that MACD is rising faster than its 9-day EMA and bullish momentum is strengthening. Sharp declines in the MACD-Histogram indicate that MACD is falling faster than its 9-day EMA and bearish momentum is increasing.



On the chart above, we can see that the MACD-Histogram movements are relatively independent of the actual MACD. Sometimes the MACD is rising while the MACD-Histogram is falling. At other times, the MACD is falling while the MACD-Histogram is rising. The MACD-Histogram does not reflect the absolute value of the MACD, but rather the value of the MACD relative to its 9-day EMA. Usually, but not always, a move in the MACD is preceded by a corresponding divergence in the MACD-Histogram.

1. The first point shows a sharp positive divergence in the MACD-Histogram that preceded a Bullish Moving Average Crossover.
2. On the second point, the MACD continued to new Highs but the MACD-Histogram formed two equal Highs. Although not a textbook case of Positive Divergence, the equal High failed to confirm the strength seen in the MACD.
3. A Positive Divergence formed when the MACD-Histogram formed a higher Low and the MACD continued lower.
4. A Negative Divergence formed when the MACD-Histogram formed a lower High and the MACD continued higher.The first point shows a sharp positive divergence in the MACD-Histogram that preceded a Bullish Moving Average Crossover.

Usage

Thomas Aspray designed the MACD-Histogram as a tool to anticipate a moving average crossover in the MACD. Divergences between MACD and the MACD-Histogram are the main tool used to anticipate moving average crossovers. A Positive Divergence in the MACD-Histogram indicates that the MACD is strengthening and could be on the verge of a Bullish Moving Average Crossover. A Negative Divergence in the MACD-Histogram indicates that the MACD is weakening, and it foreshadows a Bearish Moving Average Crossover in the MACD.

The best use for the MACD-Histogram is in identifying periods when the gap between the MACD and its 9-day EMA is either widening or shrinking. Broadly speaking, a widening gap indicates strengthening momentum and a shrinking gap indicates weakening momentum. Usually a change in the MACD-Histogram will precede any changes in the MACD.

Signals

The main signal generated by the MACD-Histogram is a divergence followed by a moving average crossover. A bullish signal is generated when a Positive Divergence forms and there is a Bullish Centerline Crossover. A bearish signal is generated when there is a Negative Divergence and a Bearish Centerline Crossover. Keep in mind that a centerline crossover for the MACD-Histogram represents a moving average crossover for the MACD.

Divergences can take many forms and varying degrees. Generally speaking, two types of divergences have been identified: the slant divergence and the peak-trough divergence.

Slant Divergence

A Slant Divergence forms when there is a continuous and relatively smooth move in one direction (up or down) to form the divergence. Slant Divergences generally cover a shorter time frame than divergences formed with two peaks or two troughs. A Slant Divergence can contain some small bumps (peaks or troughs) along the way. The world of technical analysis is not perfect and there are exceptions to most rules and hybrids for many signals.

Peak-Trough Divergence

A peak-trough divergence occurs when at least two peaks or two troughs develop in one direction to form the divergence. A series of two or more rising troughs (higher lows) can form a Positive Divergence and a series of two or more declining peaks (lower highs) can form a Negative Divergence. Peak-trough Divergences usually cover a longer time frame than slant divergences. On a daily chart, a peak-trough divergence can cover a time frame as short as two weeks or as long as several months.

Usually, the longer and sharper the divergence is, the better any ensuing signal will be. Short and shallow divergences can lead to false signals and whipsaws. In addition, it would appear that Peak-trough Divergences are a bit more reliable than Slant Divergences. Peak-trough Divergences tend to be sharper and cover a longer time frame than Slant Divergences.

Conclusion

One of the primary benefits of MACD is that it incorporates aspects of both momentum and trend in one indicator. As a trend-following indicator, it will not be wrong for very long. The use of moving averages ensures that the indicator will eventually follow the movements of the underlying security. By using Exponential Moving Averages (EMAs), as opposed to Simple Moving Averages (SMAs), some of the lag has been taken out.

As a momentum indicator, MACD has the ability to foreshadow moves in the underlying currency. MACD divergences can be key factors in predicting a trend change. A Negative Divergence signals that bullish momentum is waning, and there could be a potential change in trend from bullish to bearish. This can serve as an alert for traders to take some profits in long positions, or for aggressive traders to consider initiating a short position.

One of the beneficial aspects of the MACD is also one of its drawbacks. Moving averages, be they simple, exponential or weighted, are lagging indicators. Even though MACD represents the difference between two moving averages, there can still be some lag in the indicator itself. This is more likely to be the case with weekly charts than daily charts. One solution to this problem is the use of the MACD-Histogram.

MACD is not particularly good for identifying overbought and oversold levels. Even though it is possible to identify levels that historically represent overbought and oversold levels, MACD does not have any upper or lower limits to bind its movement. MACD can continue to overextend beyond historical extremes.

With the emergence of computerized analysis, it has become highly unreliable in the modern era, and standard MACD based trade execution now produces a greater distribution of losing trades. Some additions have been made to MACD over the years but even with the addition of the MACD-Histogram, it remains a lagging indicator. It has often been criticized for failing to respond in mild/volatile market conditions. Since the crash of the market in 2000, most strategies no longer recommend using MACD as the primary method of analysis, but instead believe it should be used as a monitoring tool only. It is prone to whipsaw, and if a trader is not careful it is possible that they might suffer substantial loss, especially if they are leveraged or trading options. Since Gerald Appel developed the MACD, there have been hundreds of new indicators introduced to technical analysis. While many indicators have come and gone, the MACD has stood the test of time.

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