After receiving many requests, I've contacted the team from DayTradeology to help explain how to use MACD AND Forex. Please let me know what you think of the Guest Blog spot.
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The MACD (Moving Average Convergence Divergence) is a trend-following momentum indicator that shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the "signal line", is then plotted on top of the MACD, functioning as a trigger for buy and sell signals when trading the forex market.
First Some History
Developed by Gerald Appel, Moving Average Convergence/Divergence (MACD) is one of the simplest and most reliable indicators available.
MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics.
These lagging indicators are turned into a momentum oscillator by subtracting the longer moving average from the shorter moving average. The resulting plot forms a line that oscillates above and below zero, without any upper or lower limits.
Benefits of the MACD
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, as opposed to simple moving averages, some of the lag has been taken out.
MACD Setup
The default settings for the MACD which we will use are:
Slow moving average - 26 days
Fast moving average - 12 days
Signal line - 9 day moving average of the difference between fast and slow.
All moving averages are exponential.
Although there are three moving averages mentioned you will only see two lines. The simplest method of use is when the two lines cross. If the faster signal line crosses above the MACD line ( The MACD line is calculated by the difference between the 26-day exponential moving average and the 12-day exponential moving average) then a buy signal is generated and vice versa.
The higher above the zero both lines are the more overbought it becomes and the lower below the zero line both lines are the more oversold it becomes.
It may also lead to a stronger signal if the signal line crosses down when it is overbought and crosses up when it is oversold.
The last common use of MACD is that of divergence.
If the MACD has made a new low and starts to head up but price continues dow making new lows that is one form of divergence (BULLISH Divergence).
Also, if the MACD has made a high and starts to head down making new lows but price continues up making new highs that is another type of divergence (BEARISH Divergence). This is also referred to as Negative Divergence and is probably the most reliable of the two and can warn of an impending peak.
There are many ways to trade the MACD but one of our favorites are too use two different time frames. All we do is establish a trend in a higher time period than the one we intend to trade. For our higher time frame we like to use the 30 min chart and then drop down to the 5 min chart when conditions have been met on the 30 min chart.
On the 30 min forex trading chart below there was a typical buy signal. The chart below (red arrow) shows the fast 9-day signal EMA (gray line) crossing over the MACD line EMA (green line).
After confirming the signal on the 30 min chart we then dropped to the 5min chart and bought the rallies wherever the MACD crossed up, confident to stay long (to buy) as long as our higher time period MACD trend in the 30 min stayed intact. If the 30 min MACD signal line were to cross down we would have closed all long positions.
Conclusion
The 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. The MACD does not have any upper or lower limits to bind its movement and can continue to overextend beyond historical extremes.
Also the MACD calculates the absolute difference between two moving averages and not the percentage difference. The MACD is calculated by subtracting one moving average from the other. As a security increases in price, the difference (both positive and negative) between the two moving averages is destined to grow. This makes its difficult to compare MACD levels over a long period of time, especially for stocks that have grown exponentially.
With some charts you can set the MACD as a histogram. 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.
That having said, the MACD still is and will always be one of the few indicators that all traders love and use daily and in many ways it is an old familiar friend you know you can rely on.
Thank you for joining us in this forex trading lesson.
http://www.daytradeology.com/
Wouldn't relative difference calculations for MACD and MACD histogram still provide the same indications as absolute difference calculations but with an additional benefit of supporting comparison over long time frames ?
i.e. MACD_relative = (fast_EMA - slow_EMA)/slow_EMA*100
MACD histogram relative =
(MACD_relative - MACD_relative_Signal_)/MACD_relative_Signal*100
Danie.....thankyou for the reply.....I was sure that the lines got crossed,that's an easy thing to happen when one tries to explain technical analysis.I like your take on confirming a good pattern on the 30min.and dropping down to a 5min to execute the trade.......take care.
Dear John,
I like to trade only the GBP/USD currency pair just now using the default settings of the MACD and looking ONLY for NEGATIVE DIVERGENCE:
"If the MACD has made a new low and starts to head up but price continues down making new lows that is one form of divergence (bullish divergence).
Also, if the MACD has made a high and starts to head down making new lows but price continues up making new highs that is another type of divergence (bearish divergence). This is also referred to as Negative Divergence and is probably the the most reliable of the two and can warn of an impending peak."
I look for negative divergence on the 1hr, then I drop down to the 15min to look for negative divergence there and then I look at the 5min for possible entries again on negative divergence. In other words I look for negative divergence within negative divergence.
I have a 60-70% success rate with this. The reason I like to trade the cable (GBP/USD) is because of it's slow and steady movement - the spread some brokers offer on the EUR/USD makes everyone trade that pair and I find it very unreliable with this particular method.
Hi Danie,
What i meant by my question is how does the MACD indicator predict future direction? Every single trading methodology (save perhaps some hedging strategies) is trying to determine what will happen in the future. You youself stated "I like to use divergence between price and the MACD in three different time frames when trading forex as a fore warning of the trend about to change."
So, how well does the MACD predict? You mention 60-70% and that you use divergences bewteen the indicator and price action. Is that about how reliable the indicator is? If so, over what timeframe, and does this hold for all forex markets?
Dear Frank,
Tx for pointing out that obvious blunder, we had our lines crossed there for a moment, you are perfectly correct. Here is what that segment should read:
If the MACD has made a new low and starts to head up but price continues down making new lows that is one form of divergence (bullish divergence).
Also, if the MACD has made a high and starts to head down making new lows but price continues up making new highs that is another type of divergence (bearish divergence). This is also referred to as Negative Divergence and is probably the the most reliable of the two and can warn of an impending peak.
Tx again.
One more thing,I would be sloppy if I did not mention that an ATR is basically the high for the day minus the low of the day and then all these differences over a period of seven days (as used in Marketclub )are added together and then divided by 7......that gives you the average daily range of a stock for a period of seven days.You could use a longer or shorter period to average,but I am satisfied with seven. Another thing,I use the close of the previous day to start my count when a stock gaps up or down,otherwise I just use the high or the low of the stock.So if the stock ran down from 80 to 77 and confirmed a bottom ( the lowest low of that timeframe,I would add that ATR to the low of that low to obtain an upside price target and subtract the ATR from the High of the highest print to obtain a downside price target.......sorry,that may sound confusing,,but once you do it a few times it becomes automatic.
Well,I can't resist,I have to tell you how the ATR(average true range)helps me day in and day out on price targets.Let's say that the atr for a stock is $5.00 and you are trading an $80.00 stock(for me higher priced stocks play out more consistently than lower priced stocks)and your stock opens in the morning @ $82.00 and you want to be long.Let the first 30 to 60 minutes stampede subside and wait for a pullback to favorite MA's,I use the 20 and 45 exponential(compliments of Adam I think,but not sure)and I buy even when the candlestick looks terrible(I trust my method implicitely).I will start with small share size(100)and give myself 25% of the atr as a loss cut in this case $1.25. Or I use pryor support if it is there. Do not be too stingy with the loss-cut for you will surely be taken out by the Market-makers,we are easy money for them.With a loss-cut of $1.25x100 shares you will suffer a $125.00 plus slippage and commissions loss if the trade goes against you. Now,let's get back to the trade,the stock opens @ 82 and pulls back to 81.Remember, you are long..... the 20ma is riding above the 45ma and both ma's are going up and the price of the stock is above or riding the moving averages,but not under, at least at the time you buy.Now add the ATR of $5.00 to previous day's close and get a target of 85.You bought in at 81 more or less,so that leaves you 4 as a profit.When the stock starts to reach 85 you will probably have all you're going to get to the upside for that day.To protect your trade use a trailing stop as the stock goes up,never end up with less than breakeven.The point I want to make is that seldom will a stock do much less or much more than its daily ATR, and seldom will a stock not do its ATR either up or down that day.Even on a day like today,most of my watchlist stocks did their ATR....Rimm and a few others were the exception,and stayed away from them for they could not give a simple forecast for price targets.Once you have experimented with this formula you may see that if your bullish stock went from 80 to 85 in the first hour of trade you could reasonably conclude that it will correct a bit and end up going sideways for the rest of the day,so move on to a better candidate (one that has not yet done its mandated ATR ).Remember that an ATR is valid to the downside as well as to the upside.....don't have tunnel vision.I hope that this longwinded comment brings an interesting element into your trading.
Hello Traders and writer on Macd.....I wouldn't trade without it.Correct me if I'm wrong,but the part about the Macd making new lows,while the security price does not make new lows is a
bullish divergence??? I'm always looking for Macd to be heading up while the security price heads down as a bullish divergence......that tells me that the security price may have put in a double-bottom, and that may be the cheapest price that I can get.....using ofcourse a tight stop-loss in case I'm wrong.And I continue this process until I get the bottom. I don't recommend this process if you are just starting out in trading,but for those who trade for a living I'm sure you will agree that the most bang for your buck comes from the bottom to up, and the top to down.I'm pleased that you mention the Macd,it is a favorite tool,and I hope that the ATR will be talked about soon,because when the Average True Range is properly incorporated in your trading plan it can do wonders.....thx
Dear John,
As with most technical indicators the MACD lags the market, but like Warren Buffet says: The rearview mirror (Past Performance) is a much better indication of what worked just now than the windscreen (Future Performance).
I like to use divergence between price and the MACD in three different time frames when trading forex as a fore warning of the trend about to change.
Together with good money management principals and sound fundamental analysis of whichever currency pair you only need to be right 60-70% of the time to show a profit over the long run.
Trading is so "easy" if you look MACD in the past.
Buy when cross "never miss" because chart adjust.
Please don't use that legging indicator. Thank you for a good post.
An excellent tool for filtering trades regardless of the market and time frame. MACD cross over also gives you an opportunity to sell out of the money options on a daily timeframe. I never take a signal against MACD, and always wait for reconfirmation on MACD before re-entering a trending market after a pullback.
Have you done any correlation studies between the MACD and future market direction? Which markets 'fit' well with the movements of the MACD indicator? So far, in my own studies I have not been able to find enough proof to disprove the NULL Hypothesis when looking at MACD signal trends and future market direction...