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How to spot momentum and trend - MACD

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forex trading
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Lesson 10

The Moving Average Convergence Divergence indicator (MACD) is one of the most popular and widely used oscillators in the forex markets. The simplicity of this oscillator often makes it the first choice for beginner traders.

Despite being categorized as an oscillator, the MACD does a splendid job of identifying the trend as well as the momentum.

The MACD was developed by Gerald Appel back in the late 70s. The fact that this indicator is still used today, and that there are many trading strategies, both manual and automated, shows this indicator has stood the test of time.

The MACD is so popular because the signals are easy to distinguish visually. Secondly, the indicator itself draws upon the moving average indicator.

Thus, as a trend following indicator, the MACD also measures momentum. The two most important aspects regarding trading are finding the trend and knowing when the momentum is the strongest and when it is the weakest.

How does the MACD indicator work?

Most traders blindly start trading based on the signals an indicator gives. Not knowing how these signals are generated and applying the information to the market context will most likely generate losses for traders. The best way to make an indicator work for you is to first understand the information it provides.

The MACD indicator is comprised of three main elements: the MACD line, the signal line and the histogram. These three elements oscillate above and below the zero line.

The indicator uses the values of two moving averages to construct the histogram. When the MACD line and the signal line start to diverge (i.e., move apart), the histogram starts to rise. Likewise, when the MACD line and the signal line start to draw closer, the histogram starts to fall.

The signal line is the 9-period exponential moving average (EMA) of the MACD line. The line is determined by subtracting the short-term moving average value from the long-term moving average value.

The most common setting for the MACD is the 12-, 26- and 9-period setting. The 12 period marks the short-term moving average, while the 26 period marks the long-term moving average. The 9-period setting is the signal line's EMAs, which smooths the values of the MACD line.

How to use MACD in Forex

In the forex markets, traders often use this indicator to determine the trend. When the trend is established, based on rising or falling momentum, traders can position long or short.

The MACD is also commonly used to detect divergences and convergences. Because it is not bound within fixed upper and lower limits, traders can identify when the indicator starts to diverge.

Typically, the MACD and the signal line tend to converge with price. Higher highs or lower lows in price are depicted by similar higher highs or lower lows on the MACD itself. When that fails to react according to the price, a divergence is detected, which can suggest an impending correction in price.

MACD Signals

The signals are generated based on various combinations. The most common is the signal line crossover. This occurs when the MACD line crosses over or under the signal line. As one would take a buy or a sell position based on a short-term and long-term moving average, the same concept applies to the MACD and the signal line crossover.

When the trend is strong, the crossovers can represent powerful signals. However, traders must apply due diligence as the MACD is also prone to give false signals. Utilizing the histogram can help in one way to avoid these false signals.

A bullish MACD line and signal line crossover with a histogram above zero can indicate an uptrend with a strong bullish momentum.

Likewise, a bearish MACD line and a signal line crossover with a histogram below zero depicts a strong bearish momentum.

MACD trading strategy

Traders can use the MACD to set up a forex strategy. It is essential to take Long or Short positions when the momentum is just starting to build. This will enable your position to eventually close with profit.

MACD Buy Signal

For Long position, wait for the MACD and the signal line to form a bullish crossover. Then, wait for the histogram to turn above the zero line. This will suggest the bullish momentum is starting to build.

After the first candlestick is closed, you can go Long at the open of the next candle and hold based on the chart timeframe you are using.

MACD Buy Signal

In the above example, you can see USDJPY pair could be purchased following the generated bullish signal. This comes after the bullish MACD and signal line crossover, which was immediately followed by the histogram turning above the zero line.

MACD Sell Signal

You can sell USDJPY when the indicator signals bearish momentum and trend. For this, look for the MACD and the signal line to make a bearish crossover. Then, simply wait until the histogram starts to fall below the zero or when it starts to decrease.

It is ideal to also look for price that has been in a rally as it could suggest declining momentum. Once the signal is formed, you can Short the currency pair at the open of the next candlestick.

MACD Sell Signal

The above USDJPY chart shows the MACD line and the signal line forming a bearish crossover. This comes after the histogram starts to fall below the zero line.

The MACD oscillator is simple, and it can generate good trading signals. However, this does not mean you can make profit on each generated signal. As a trader, it is important to examine the whole picture, including the price action and fundamental data.

The above strategy is just some of the many ways you can use the MACD indicator to trade forex.