Greetings to all who are reading. Financial markets are
dynamic and complex environments where millions of investors and traders
worldwide take part in buying and selling activities daily, causing prices to
change instantly. In this fast-moving world, we are required to act accurately
and decisively at all times. However, predicting and comprehending market
movements often becomes evident as a intricate task. The intricacy and
uncertainty of financial markets have directed traders like us towards various
analytical tools to make better decisions and understand market trends. One of
these tools is technical indicators. Technical indicators consist in analyzing
market data and showing mathematical calculations on charts and indicators.
These indicators help us in evaluating market trends, determining entry and
exit points, and predicting future price movements. In the Forex market, price
movements can often cause emotional reactions, which can lead us to make
incorrect decisions. This is where technical indicators come into play and
provide us with remarkable advantages in minimizing emotional decisions. Since
technical indicators are based on objective data, they offer the opportunity to
analyze the market without emotional influences. This helps us make more
consistent, unbiased, and rational decisions. Moreover, indicators save us time
due to their ability to swiftly analyze large amounts of data, allowing us to
quickly identify signals suitable for specific trading strategies without the
need to manually process market data.
In this article, we will try to explain the Moving Average Convergence Divergence (MACD), a leading indicator in technical analysis. In the following sections, we will explore how the MACD is calculated, its components, and how it can be applied in trading.
What is the MACD Indicator?
In 1979, Gerald Appel developed the MACD line, and then in 1986, Thomas Aspray added the histogram feature. The Moving Average Convergence Divergence (MACD) indicator, tracking the relationship between two different exponential moving averages, is a widely used tool in technical analysis that assists in forming trading strategies in financial markets. So, if you were to ask why the MACD indicator is so popular, the answer is quite simple. This is because the MACD is formed by the intersection of three distinct types of indicators. Among these types, it stands out as a Trend indicator, which is based on moving averages; a Momentum indicator, expressed with a histogram; and a Signal indicator that utilizes moving average crossovers to generate buy and sell signals. This is because the MACD indicator gives us a comprehensive overview of the market momentum, trends and possible reversal points.
Components and Calculation of the MACD Indicator
The MACD indicator is formed by the combination of three main components as a standard. These are two exponential moving averages, a signal line, and a histogram. Let’s now look at the details of how these components are calculated.
1. MACD Line. Typically shown in blue on the indicator, this line is calculated by subtracting the 26-period exponential moving average value from the 12-period exponential moving average value:
12 EMA - 26 EMA
In other words, the indicator automatically calculates the
difference between these two exponential moving averages to draw the MACD line
(blue line). Here, to calculate the 12-day EMA, the initial EMA value is taken
as the closing price of the first day. The EMA value for the second day is
calculated using the formula EMA = (Closing Price - Previous Day's EMA) × (2
/ 13) + Previous Day's EMA, and these steps are continued to calculate the
12-day EMA value for each day. The same method is used to calculate the 26-day
EMA.
2. Signal Line. Also known as the trigger line, this
line is shown in orange or red on the indicator. The signal line is calculated
by taking the exponential moving average (EMA) of the last 9 days’ values of
the MACD line.
3. Histogram. Presented in bar graph format, the
histogram illustrates the distance between the MACD and the signal line using a
series of changing-length lines.
Histogram = MACD Line - Signal Line
As prices change, the difference between the MACD line and the signal line also changes. The histogram makes this difference easily readable in the form of bar graph. In the middle of the histogram, there’s a 0 (zero) line. The 0 line signifies the intersection point of the MACD line and the signal line, determining their relative positions. The zone above the 0 line is the Positive zone, while the zone below it is the Negative zone. When the MACD line is at the 0 line, the 12-day EMA equals the 26-day EMA (12 EMA = 26 EMA). In the Positive zone, the 12-day EMA is greater than the 26-day EMA (12 EMA > 26 EMA), and in the Negative zone, the 12-day EMA is smaller than the 26-day EMA (12 EMA < 26 EMA).
Trading with the MACD Indicator
The MACD indicator is widely used in financial markets for
trading purposes. In the indicator, when the MACD line crosses above the 0
(zero) line, it signals an upward trend. Conversely, when the MACD line crosses
below the 0 (zero) line, it indicates a downward trend. If the MACD line (Blue
line) crosses the Signal line (Orange line) above the zero line in the negative
zone, we enter a Buy order. If the blue line intersects the orange line
in the positive zone, it would be more reasonable to enter a short-term Buy
order. If the MACD line (Blue line) crosses below the Signal line (Orange line)
in the positive zone, we place a Sell order, if it crosses in the
negative zone, we enter a short-term Sell order.
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| Trading via MACD in the USD/CAD chart |
In addition, we can also trade with divergences in the MACD
indicator. The above example illustrates trading with positive regular
divergence and negative exaggerated divergence on the US Dollar/Canadian Dollar
chart. If you are interested in how to trade with divergences, check out this
article “Divergences”.
Don’t lose sight of the fact that, trading in the Forex market offers high-profit opportunities, but it also comes with a high level of risk. Due to price fluctuations, leverage usage, and other factors, there is a possibility of losing the entire invested capital. It’s important to remember that making buying or selling decisions based solely on a single indicator is risky, including the MACD indicator. In particular, during times of sideways trends in the market, the MACD indicator can produce incorrect signals. Therefore, while technical indicators can be powerful tools to support buying and selling decisions, they should not be used alone. Every investment decision requires careful analysis and a well-thought-out strategy. Technical analysis tools generally yield more reliable results when used in conjunction with other indicators and analysis methods, providing a more comprehensive understanding. Trade smart, succeed well!