The popular MACD indicator monitors trend deviation by turning two trend-following indicators (moving averages) into a momentum oscillator through subtracting the longer moving average from the shorter moving average. This gives users insight into both the trend following and momentum characteristics of the currency being analyzed. A third moving average (MA) plotted separately on the chart (known as the signal line) smoothes the MACD line, crossovers of which with the MACD line generate buy signal
Trading with the MACD Indicator
Where the fast EMA breaches the slow EMA to the upside positive readings will be shown which increase in size as the fast EMA accelerates further away from the slow EMA. The MACD line measures this convergence and divergence of fast and slow exponential moving averages. The signal line (an EMA which smoothes the MACD indicator line) helps indicate the direction of the change in the MACD line over time.
The MACD histogram represents the difference between the MACD line and the signal line, it is positive when the MACD line is above the signal line and negative when the MACD line is below the signal line. The MACD is useful for trading trends, but being unbounded (since the MA’s can continue to diverge) it is not very useful for identifying overbought and oversold levels and therefore should not be applied in ranging markets where it can especially prone to whipsaws. It is however, very useful for showing the increasing and slowing momentum of a movement. Perhaps the best results can be achieved by using it to point to potential changes in trends through a loss in momentum via divergences in price with the MACD indicator.
Trade Signals
Signal line crossovers – these occur where the MACD line crosses the signal line to generate buy and sell signals. As a moving average of the indicator, the signal line lags the MACD and helps identify MACD turns. Buy signals are given when the MACD turns higher and crosses the signal line, sell signals are given when the MACD turns down and crosses below the signal line. Traders should exercise due diligence with the signals especially at extremities in price. Strong moves in price can push momentums to extremes, as the price move slows crossovers often occur even though the price move may continue. Volatility can also increase the number of crossovers.
Centerline crossovers – these occur where the MACD line moves above or below zero to turn positive or negative. This occurs where the shorter period EMA moves above (bullish crossover) or below the longer (bearish crossover) period EMA. Centreline crossover trades will work well when there is a sustained trend as the MACD will remain positive during sustained up-trends and will remain negative during sustained downtrends.
Divergences – divergences occur when the MACD diverges from the price action of the underlying currency. A bullish divergence forms when a currency trades at new low while the MACD forms a higher low. The lower low in price affirms the current downtrend, but the higher low in the MACD indicates less downside momentum, which can foreshadow a trend reversal. A bearish divergence forms when a currency trades at new high while the MACD forms a lower high. The higher high in price affirms the current uptrend, but the lower high in the MACD indicates less upside momentum foreshadowing a potential trend reversal.
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