The MACD indicator charts the convergence and divergence of short term and long term moving averages. The principles applied are similar to using crossovers with two moving averages (see Moving Averages article), which is fundamentally what the MACD does. The MACD indicator takes moving average analysis a step further.
MACD shows graphically when the short term movements of price rise or fall faster than the longer moving average would suggest. This indicates the
recent trend. During an uptrend, for example, the shorter moving average is rising faster than the longer moving average, creating a bigger gap (difference) between them.
MACD has several uses and can provide a trader with these pieces of information.
- When the lines in the MACD indicator cross they generate buy and sell signals.
- Centerline crossings indicate bearish and bullish markets or sentiments.
- The oscillation of the indicator shows overbought and oversold levels.
- Divergences can spot market tops and bottoms.
By the end of this article you should be able to go back to this chart and using MACD, decipher the information it gives on the Euro/Dollar pair’s movements.
The MACD is an
oscillator that looks at the difference between two exponential moving averages. When plotting a MACD indicator only two lines show up even though 3 exponential moving averages are used in the indicator's construction. The periods of the 3 moving averages at work by default are set to 12, 26, and 9.
- The MACD line, referred to as the fast line, is the difference between the 26 period and the 12 period exponential moving averages of closing prices. (Blue line in figure 2).
- The signal line is the 9 period exponential moving average of the MACD line. (Red line in figure 2).
- A buy or sell signal is generated when the MACD line and the signal line cross.
The histogram portion of the MACD indicator shows the difference between the fast and signal lines.
The middle panel is an example of the MACD indicator as it looks in the MT4 Software.
MACD-Line Indicator In the bottom panel, a different way to visualize MACD is presented, another indicator called the
MACD-Line indicator. The blue fast line is replaced by a histogram and the signal line remains unchanged. The analysis in both panels is the same (for the most part); they simply look different. It is easier to do some analysis like centerline crossovers with the MACD-Line indicator. However, it does not have the histogram part (the divergence) of the regular MACD indicator that shows the difference between the two lines.
This technique resembles the double crossover method of generating signals when using two moving averages. The MACD indicator reduces the lag inherent in using moving averages alone. In this example we will apply the signals as an automatic trading strategy, without any analysis.
- A buy signal is generated when the fast line crosses above the signal line.
- A sell signal is generated when the faster line crosses below the signal line.
- Sell Setup - There is a buy signal for the Dollar in the middle of September (i) when the MACD line crosses above the signal line. It is followed by a sell signal in the middle of October (ii). These two trades (buying then selling) might not have made much of a gain (and possibly even a loss), but they do nonetheless set one up to be in a good position for the upcoming downtrend.
- Potential Gains on Trending Market (& Whipsaw) - A trader that shorts the Dollar during the October (ii) sell signal would ride the appreciation of the Yen until December (v) when there is the next (true) buy signal for the Dollar. However there is a whipsaw beforehand.
- Whipsaw - In November (iii & iv) there are misleading buy and sell signals. When using indicators that use exponential moving averages a trader needs to always be concerned about dramatic rises and falls in price in a single day as it skews the data used in calculating the averages. These types of moves are usually brought about because of some news event and can produce “noise.” If the trader was patient he would see that the one session upswing was met by just as dramatic a downswing within two sessions and thus avoided the “whipsaw.” This is easy to say after the fact, therefore it is a trader's ability to gauge and withstand whipsaws that makes one a good or poor technical trader. If one is following the automatic trading technique they would lose money on the whipsaw.
If one is a novice trader and follows the whipsaw or is more experienced and doesn't, both are in a position to collect the rest of the down movement from (iv) to (v).
Crossover Signals Continued
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From the previous page we left off with a long position after signal (v) at the start of Decemember.
- Enter Trading Range - After the buy signal in December (v), the period in January is quite volatile. There is a succession of buy and sell signals (vi, vii, viii, & ix). Another warning of using an indicator that uses exponential moving averages is that they are poor predictors of what will happen during trading ranges (also known as ranging markets or sideways trends). There are ranging markets in January and in Feb/March. A trader using MACD crossovers as an automatic trading system would probably incur losses over this period.
If a trader recognizes the trading ranges he will avoid heeding the/ MACD’s signals and probably save on transaction costs and whipsaws. A day trader or another shorter term investor may adjust the MACD indicator or use an indicator that is better suited to ranging markets (RSI) to try and capture the gains from those intra-monthly swing movements.
- Entering and Exiting a Second Trading Range – A trader is holding the Dollar after buying in late January (ix) and will short the Dollar when a sell signal appears at the end of February (x). He would then buy the Dollar again in mid to late March (xi).
An experienced trader may be holding the Dollar (through the ranging markets) after buying in the beginning of December (v). He may sell in February (x) and buy in March (xi) to lock in some of his gains, or he may wait out this second trading range until the Dollar breaks out and the MACD gives the next sell signal. Of course his analysis would have to be telling him that it is a good idea to hold the Dollar over the Yen for this period.
- Uptrend and the Last Sell - Whether a trader is a novice or experienced, from the signal (xi) to (xii) it is a relief to finally ride a trend again, after all of that ranging activity the past four months. In this case the trend is an appreciation of the Dollar. In April (xii) the uptrend peaks and the MACD lines converge to give the final sell signal in this example. The Dollar has appreciated as high as 108.50 at this point.
The MACD indicator acts as an oscillator. It moves up and down around a centerline at zero. The centerline is the neutral measurement and the oscillation up and down by the MACD lines represent if the currency is overextended (similar to RSI).
- Overbought conditions occur above the centerline, but are more prominent when they are far above. (Black arrows in Figure 5)
- Oversold conditions occur way below the centerline. (Red arrows in Figure 5)
In the VT software readings for the upper and bottom levels change depending on the currency pair (unlike RSI because calculations are more complex). A trader needs to examine past data to see what the appropriate levels are.
A trader using past upper and lower boundaries would sell the currency pair when it is overbought and buy the currency when it is heavily oversold. Buy signals come in mid January and mid June, while sell signals occur at the start end of 2004 and in August.
In mid-March, there are two arrows which would indicate a sell because the MACD indicator touched the upper boundary. The reversal in price that the indicator predicts (March 1st) is short lived and comes back up again. The currency enters a trading range. As mentioned before, trading ranges create problems for indicators that use exponential moving averages. Nevertheless, sometime in there, a trader using this strategy should get a short Euro position and wait for a buy signal that comes in June.
Using MACD’s oscillations as signals, it seems from this example that a trader could make impressive gains in a long term strategy over the seven months presented. The problem is that such easy signals will not always present themselves as they do so perfectly in this particular example. This is also a daily chart and signals present themselves over long periods of time. There may be long periods when the upper or lower levels are not touched. Also past levels of what is oversold or overbought may become unreliable as the market conditions change. However the principles presented can be used for all time periods.
Centerline crossovers generate signals of market sentiment and can guide or confirm MACD crossovers.
- When the fast line crosses below the centerline it is an indication of a bearish phase in the market.
- When the fast line crosses the centerline going upwards, it is an indication that the market is switching from a bear to a bull sentiment.
- These signals will lag the market, but can act as good confirmations of MACD crossovers.
- The MACD-Line indicator might serve as a better visualization of these signals.
Centerline crossovers can not be used as effective buy and sell signals. They are shown as small black rectangles in Figure 6 and are obviously too late at giving good entry and exit points. If one moves the lines separated the bullish and bearish periods back some days (half a month), they would correspond better with the uptrend and downtrends seen on the chart. The MACD-Line indicator may be better at showing opportune times to enter or exit the market. These signals are shown as black circles in the MACD-Line panel. They come when the histogram peaks and starts reversing. This variant of oscillation does not need past levels to guide it as was the case in the previous section. However, this strategy requires good analytical skills in order to judge whether a peak is valid or not.
Centerline crossovers can help to determine if a MACD crossover is something to act on or ignore, as it may be part of trading range. The sentiment of the market will cause certain signals (like a sell MACD crossovers during a bearish phase) to carry less weight. In the next section, using Figure 6, we combine all three techniques; MACD crossovers, centerline crossovers and the peaking (ebbing) MACD-Line indicator.
Combining MACD Crossovers and MACD-Line
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On this page we will show the three interpretations we have learned so far in one example. This can show you how the three signals work together to confirm signals. Of course, it is very important to not rely on only one indicator when placing trades.
There is a MACD Sell crossover to end 2004. It is followed by a steep decline in the MACD-Line histogram and then a centerline crossover to bearish phase. The combination of these three factors confirm, according to MACD, the sell signal.
- MACD-Line hits a low and reverses. It is followed by a Buy MACD line crossover. MACD then heads towards zero and crosses the center line. This centerline cross, again according to MACD, validates the trade. Now the trader would wait for the bull market to peak to sell.
- Before (3) there is a minor peak, but act on it or no, at (3) there is a MACD line crossover indicating for a trader to Sell. There is a fast decline in the MACD-Line panel towards bearish territory.
- Caution – This buy crossover signal is suspicious because, using our MACD strategy, we are looking for a buy signal in bearish territory, not in bullish territory. If one longs the euro, there is a sell signal soon, which is in line with the thinking at (3), so a trader using MACD would sell. This sell (or the one from (3)) is followed by a centerline crossover which "validates" the trade.
Wrong Signals
- In mid-May the histogram looks like it reaches a bottom and there is time to catch the price at this level if one believes price will head back up. A Buy signal is generated when the MACD lines crossover. From our previous analysis of MACD, a trader using this indicator expects the MACD line to keep heading towards zero and price to increase (as is projected on the figure).
- Market Hiccup – However, contrary to our predictions something happens here to move the market deeper into bear territory. Probably some news event acted as a trigger to make the market do something unpredictable (the French reject the EU Constitution in this case). Hopefully, one was trading with defenses. Using stops, you can either sell again as MACD starts decreasing more, or stay out until the new low and buy when MACD reverses and crosses over one more time.
- By mid-June bears are done selling the Euro and we see the MACD-Line histogram reverse. One has time to act on it and Buy. The market seems frazzled after the unexpected movements seen in (6). The buy is confirmed when MACD line heads towards zero and then there is a centerline crossover.
- Either at the first (end of July) or second peak (mid August) - a trader should sell. The first peak might have been caused by another event that triggered a market hiccup. Can you find out what? Check our Forex Capsule for clues. (Here’s a hint: Starts with China, ends with revaluation).
To spot divergences one looks at the MACD lines and the price line. Out of the three signals we have discussed, a crossover of the MACD and signal lines, zero line crossovers and divergence, this last one can be considered the strongest signal.
- Negative or Bearish Divergence - It is usually a signal of a market top when price makes new highs, while the MACD indicator does not match its previous highs. The chance that there will be a market top is even greater if MACD is well above the zero line or shows an overbought tendency.
- Positive or Bullish Divergence - A positive divergence occurs in reverse. The MACD indicator is well below the zero line and begins making new highs, and at the same time price continues declining. This is usually an early signal of a market bottom.
- In the middle of June, the MACD line (in blue) starts to inch upward while the price of the Euro continues its downward trend and keeps declining. This is a positive divergence. After a positive divergence, there is a good chance that the currency is due for a reversal and here an upward movement. In the months of July and August the price succumbs to the buying pressure and rises.
- The negative divergence works in a similar way to a positive one, with everything happening in reverse. Price reaches a higher peak in the beginning of September, but the MACD line does not reach a higher high. This classic symbol of divergence means a reversal of the uptrend may be looming. The price chart shows how the price falls almost immediately after the MACD line fails to reach a new high.
The trader in this example would have to have a long term mentality since the trades come on a daily graph and the divergences come almost three months apart. If one bought the Euro (1.1900) in early June after seeing the positive divergence, and sold Euro (1.2500) in early September, the position changed near 600 pips. The divergence signals, in this example, were very good in predicting both the entry and the exit points. Divergences can happen on shorter timeframes, but one may want to adjust the periods used in the indicator.
MACD is one of the strongest and most popular indicators in technical analysis. We have shown how it can be used to generate signals using crossovers, identify overbought and oversold levels, along with market tops and bottoms, and how to use positive and negative divergences to predict upcoming trend reversals. It’s this degree of versatility that makes MACD such an important tool to technical analysts.
One should be aware that it does not work well in trading ranges and can be affected by dramatic rises in price in one day that may create whipsaws. Identifying such markets and staying out is very important to getting the max benefit out of the MACD.
Moving Average Convergence Divergence (MACD) Summary |
The MACD indicator is one of the simplest, most reliable, and most commonly used indicators available. The MACD indicator is a momentum oscillator with some trend-following characteristics. |
Trend Identification |
Interpretation |
Description |
Results |
1. Trend |
Fast line is rising faster than the signal line. |
Uptrend |
Fast line is falling faster than the signal line. |
Downtrend |
2. Oscillation |
MACD lines are (way) above the centerline. |
Overbought |
MACD lines are (way) below the centerline. |
Oversold |
3. Center Line Crossovers |
Fast line crosses below the centerline. |
Bearish phase in market. |
Fast line crosses the centerline going upwards. |
Bullish phase in market. |
Signals |
1. MACD Crossovers (avoid whipssaws and trading ranges) |
Fast line crosses below the signal line. |
Sell signal. |
Fast line crosses above the signal line. |
Buy signal |
2. MACD-Line peaks. |
When the MACD-Line histogram peaks (ebbs) and starts reversing. |
Entry/Exit signals. |
3. Negative or Bearish Divergence |
MACD lines are well above the zero line, and start to weaken while price continues to move up. |
Early signal of a possible market top or sell signal. |
4. Positive or Bullish Divergence |
When the MACD lines are well below the zero line and start to rise, but the price continues declining. |
Early signal of a possible market bottom or buy signal. |
