MACD or Moving Average Convergence-Divergence is one of the most popular technical indicators for its multiple benefits, from identifying entry opportunities to divergence trading. How to use it effectively?
What is the main reason why many forex traders failed to generate profits consistently? The thing is, most traders impatiently wait for the perfect trading setup to enter the market. After waiting for several minutes, hours, or days (depending on the time frame), they may not get the trading signal.
Upon experiencing this condition, they usually act rashly to open trading positions without the right trading setup. In this case, their fate will rely on luck. Any outcome from the trades, whether it is a loss or profit, is due to luck, not the trading setup.
Another case is they have a good trading position, but they exit too early with small rewards because they are worried to lose their profit. They are not patient enough to hold their position as planned, so they limit the profit they can get.
The MACD indicator can overcome this problem because their slow response prevents traders from making entry or exit too early. When other indicators or even the price action shows a signal, MACD would warn traders to wait and prevents them from getting trapped by the reversed trend direction.
Many professional traders in the stock market, forex, commodities, and other assets rely on MACD signals. Still, it is important to know that MACD is not the "holy grail" indicator that should be trusted on 100%. After all, the indicator is still based on past prices and thus can be unreliable at certain market conditions.
How Does MACD Look?
The two most common MACD layouts are displayed in the following chart. A is for the popular standard version of MACD in the MetaTrader platform. It consists of MACD signal charts and histograms. Meanwhile, B is the traditional version which consists of MACD charts, signal charts, and Oscillator Moving Average (OSMA) in the histogram (MACD value minus the signal).
Despite the visual differences, both types of MACD have the same ability to provide ideal information about price trends, overbought and oversold signals, divergence indications, and so on.
Gerald Appel, a trader and analyst who built the MACD indicator has defined the difference of Exponential Moving Average period 12 (EMA-12) and EMA-26 as the basis to generate the signals. This results in the formation of MACD's main line. On the MACD traditional layout, the signal line is a moving average of MACD-9.
As a trader, you might not need to know the calculation of the MACD parameter, but if you want to program and modify an EA (Expert Advisor), you must know how to calculate these parameters:
- MACD main line: EMA (Close, 12) - EMA (Close, 26)
- Signal line: SMA (MACD 9)
- Histogram Oscillator Moving Average (OSMA): MACD main line - signal line
On the MetaTrader platform, the main line is shown as a histogram and the signal line is in the form of a chart. Meanwhile, OSMA is shown as a separate indicator. On other trading platforms, MACD's main line and the signal line may be shown in one chart along with the OSMA.
How to Use MACD: The Simple Way
The extended version is similar to the MetaTrader platform layout; the histogram has two distinct colors to differentiate the bullish and bearish signals. In its implementation, the Extended Version does not show the signal line (SMA is set to 0). However, it can be shown if you really need it by setting the SMA signal to 9.
In the picture above, you can see a strong trend along with EMA-12 and EMA-26 lines that are getting wider in some places. If you compare it with the MACD histogram, the EMA widening usually ends with a crossing that is in line with the histogram's change of position from the 0 level. This is indicated by the yellow lines that highlight the crossing of EMA lines and the position change in the MACD histogram. The blue histogram shows a strong bullish sentiment and the red one shows a bearish sentiment.
Based on the trading rules for the intersected two moving average lines, a buy signal can happen if the EMA-12 line crosses the EMA-26 from below or the MACD is bigger than zero. Meanwhile, the sell signal happens when the EMA-26 line crosses EMA-26 from above or the MACD is smaller than zero.
With the colored histogram, you can also anticipate the buy signal earlier when the bullish sentiment is strong (A area). Both EMA lines intersect each other and MACD is above the 0 level (B area). A similar thing happens for the sell signal anticipation; when a bearish sentiment can be detected earlier in the C area, which is eventually followed by a decline from MACD histogram below the 0 level (D area).
If you are an aggressive trader, you can make a buy entry when the MACD is in the A area. No need to wait for the MACD to move above zero (B area). You can also make a sell entry when MACD is in the C area. However, it is better to confirm the signals with price action or other indicators to get better profitability.
See also: Four Common Active Trading Styles
MACD Prevents Trading Against the Trend
As mentioned before, the MACD indicator can help us avoiding loss caused by trading against the trend. What happens frequently is when the candlestick formation and trend indicator (such as Bollinger Bands) show a trend reversal, MACD usually shows the opposite.
You can just anticipate to open trades based on a price action method without MACD indicator assistance. Yet, you should know that price action analysis is quite tricky and very subjective. It also needs adequate experience for understanding the price patterns correctly. In this case, the MACD indicator can help to anticipate the trend movement.
The following is a trend reversal signal by Bollinger Bands and a candlestick pattern:
The candlestick pattern shows a pin bar formation (reversal). The price starts to go down after the lowest price of the bar is re-visited. They go together with the breakout from Bollinger bands. It is then safe to assume that a reversal to the downside will be formed.
This seemingly perfect set up will attract you to open a sell entry with a stop loss above the pin bar's high. However, what happens later? As described in the chart below, your stop loss is quickly triggered before your sell position generates a substantial profit.
The price does not reverse to a bearish direction and turns to rise higher instead. If you look at the MACD histogram, the bars are still making a higher high, showing that bullish sentiment is still in control and the price trend can continue to go up. You would not make the mistake of making a sell position if you pay attention to MACD and not be blinded by the confluence of the pin bar and Bollinger Bands' indications. In other words, the MACD indicator is indeed useful in warning you to not trade against the trend.
See also: Trade By Following Or Against The Trend?
Overbought and Oversold
The situation of overbought takes place when the histogram line is above the zero levels (positive) and the length of the bars decrease after peaking. Conversely, the oversold happens when the histogram line is under the zero level (negative) and the length of the bars shorten after bottoming to a certain point.
If you are a trend follower, you will definitely make a buy entry based on the formation of a bullish engulfing pattern. At the same time, the MACD histogram line shows a bullish outlook too. But, what happens next is a bearish reversal:
After rising and reaching the upper band of the Bollinger Bands, the price decreases. This situation happens because the MACD actually shows an overbought condition in which the histogram bars have peaked and start to decline afterward. Making trades near the higher high point of MACD bars should be done and monitored carefully because it can turn into an overbought signaling a price reversal.
How to Use MACD's Signal as a Confirmation
As discussed in advance, MACD may help in confirming the trend direction. Traders just wait for one or two bars of the histogram before deciding to make an entry. It is not only for the trending market but also for helping to confirm the ranging market where the overbought and oversold signals can be optimized.
Nevertheless, the MACD indicator must be used only as a confirmation tool. The main indicator is still the price action from the chart trading and other technical indicators that you usually use, such as moving average or Bollinger Bands. The most frequent combination used is of price action, trend line, and MACD indicator. The MACD confirmation is in the breakout of the support or resistance level. The example is as follows:
In the picture shown above, the trend line serves as a valid support line. You need to wait for the breakout on the support line before opening a sell position. The MACD indicator supports that notion as the bars have formed a higher high before heading lower, indicating that the price is now overbought. When the price does break the support line and is closed below it, the MACD histogram confirms the reversal by showing declining red bars. The sell position can be triggered on the next candle opening, with the price above the trend line as the stop loss.
See also: How to Trade With Trend Lines
You can make the second support line for predicting the next breakout if you want to look for other opportunities. Make sure to always include MACD signal as a confirmation. Otherwise, you may be tricked into opening another sell position when the price breaks the second support. Why is it just a trick? Find out below:
Although the price action makes for a solid sell signal, the MACD indicator shows an oversold condition. The MACD histogram bars are indeed below the zero level when the break happens, but the bars have been forming a higher low which indicates that the bulls have tried to overtake the market from the bears. Therefore, it's not surprising that the break does not materialize into a promising downtrend continuation that can be capitalized with a sell position.
Convergence and Divergence
Convergence -Divergence terms in MACD means the comparison of the price movement and the MACD indicators (in lines or histogram). Convergence means "the meeting of price and the MACD line or histogram". The points are seen as if they are about to meet or converge. Meanwhile, the divergence happens when the price and the MACD indicator signal seem to move away from each other, thus creating a divergence.
The rules of trading with divergence and convergence are that the price movement eventually will change and follow the direction of the MACD indicator movement. However, you should not carelessly make an entry as soon as you see a convergence or divergence. You need to confirm the signal with price action or other indicators.
Forex traders are generally used to oscillator indicators such as MACD, RSI, CCI, Stochastic, and so forth. Even in a forex demo account platform, those indicators are commonly known for their oscillating levels. However, many of them do not have the idea about the alternative ways of using a MACD indicator. For an easy guide of using MACD as a trend indicator, check out Predicting Trends Using MACD in Forex Trading.