Enhance Your Understanding of the MACD Indicator

Enhance Your Understanding of the MACD Indicator, FP Markets

Reading time: 12 minutes

Although the author of several well-known trading books, Gerald Appel is perhaps most recognised as the developer behind the Moving Average Convergence Divergence indicator (MACD), introduced to the world in the 1970s. Interestingly, Appel also founded Signalert Corp. in 1973, a widely read newsletter to this day called Systems & Forecasts.

Over the years, the MACD has become a household name among the technical analysis community, known for its simplistic, yet effective, approach.

Regrettably, traders seldom use the MACD to its full potential. This is where the following article may help.

 

Moving Average Convergence Divergence Indicator Defined

The MACD, often pronounced as either Mac Dee, or M-A-C-D, is designed to produce trend-following signals based on moving-average crossovers. On top of this, the MACD serves as a momentum indicator (or oscillator), helping decipher when a trending market is gaining/losing momentum.

The MACD value determines momentum by way of exponential smoothing, calculating the difference between two exponential moving averages (EMAs fall under the umbrella of trend-following indicators—a moving average placing more weight on recent price data).

The MACD value (MACD line) is then further smoothed in the shape of an additional EMA, referred to as a signal line. Most charting packages also provide a histogram. Furthermore, unlike other momentum oscillators such as the relative strength index (RSI) or stochastics oscillator, the MACD is unbounded.

Default settings on MetaTrader 4 (MT4), applied by selecting Insert > Indicators > Oscillators > MACD, are often confusing for newer traders. The MACD’s histogram is displayed as the outline of the signal line (see figure 1.A). Therefore, the traditional histogram’s calculation is not visible.

Figure 1.B, however, represents more of a traditional design, working with the MACD value, the signal line and histogram, which can be installed for free via the MQL5 community.

Indicator colour schemes will, of course, be dependent on the charting software. Though the majority of the time traders are free to adjust colours to suit personal preferences.

Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 1.A: Source: MetaTrader 4 EUR/USD daily chart with default MACD indicator applied)

Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 1.B: Source: MetaTrader 4 EUR/USD daily chart with adapted MACD indicator applied)

 

MACD Calculation

The two default EMAs making up the MACD value are 12 and 26 periods (periods refer to the timeframe—the MACD operates as both a short-term and long-term indicator). The signal line is a 9-period EMA of the MACD value, and the histogram calculates the difference between the MACD and signal line. Note, closing prices are often used in the calculation.

 

Calculation:

MACD value: 26-period EMA – 12-period EMA

Signal line: 9-period EMA derived from the MACD value

MACD histogram: MACD value – Signal line

The above settings are considered default periods, presumably established by the developer. Yet, traders are free to modify settings to suit their trading strategy.

It is important to recognise the indicator’s moving averages are not derived from price. The MACD is the difference between two EMAs, the signal line is derived from the MACD value and the histogram is derived from the difference between the MACD value and the signal line.

MACD strategies

Traders use the MACD in a number of ways to generate trading signals, seeking centreline crossovers, signal line crossovers and divergences.

Because the MACD is unbounded, many believe the indicator is unable to pinpoint overbought and oversold levels. This is not true; traders establish overbought and oversold levels based on historical values.

 

Centreline Crossover

The zero-centreline (or zero line) crossover is a common approach, consisting of bullish and bearish centreline crosses.

  • A BULLISH centreline cross forms after the MACD value crosses ABOVE the zero centreline. This is due to the 12-period EMA crossing above the 26-period EMA.
  • A BEARISH centreline cross forms after the MACD value crosses BELOW the zero centreline. This occurs due to the 12-period EMA crossing below the 26-period EMA.

A bullish cross implies price action gaining traction to the upside, while a bearish cross signifies price movement may navigate deeper water.

A MACD value advancing, north of the zero centreline, means the 12-period EMA is diverging further above the 26-period EMA. This informs the trader of increased momentum to the upside. Likewise, the MACD exploring territory beneath the zero centreline shows increased downside momentum (the 12-period EMA is diverging further below the 26-period EMA).

As demonstrated in figure 1.C, centreline cross signals provide reasonably good points of entry, despite its lag.

Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 1.C: Source: MetaTrader 4 EUR/USD daily chart showing bullish and bearish centreline crosses)

 

MACD Crossover—Signal Line Crossovers

Signal line crossovers are common techniques.

The signal line, as underlined above, is a 9-period EMA of the MACD value—a moving average of the MACD. Consequently, the signal line is the slower moving average of the two.

Much like traditional moving average crossover strategies, a buy signal forms after the faster moving average (the MACD value) crosses above the slower moving average (the signal line)—a bullish crossover, and sell signals stem from the faster moving average crossing below the slower setting—a bearish crossover.

These movements are recognised as indications the trend is likely to accelerate in the direction of the crossover.

Figure 1.D demonstrates a number of bullish (blue) and bearish (red) signal line crossovers.

 

Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 1.D: Source: MetaTrader 4 EUR/USD daily chart showing bullish and bearish signal crossovers)

 

Overbought and Oversold

Due to the MACD indicator working with an unbounded surface, many traders believe it is unable to produce overbought and oversold signals, like the RSI.

While boundaries are undetermined on the MACD, some traders opt to apply limits based on historical values. Figure 2.A shows overbought and oversold areas derived from historical movement, which, as you can see, often serves well as upper and lower borders.

Some traders look for bullish/bearish signal line crossovers to form around these overbought and oversold areas to add confluence.
Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 2.A: Source: MetaTrader 4 EUR/USD daily chart showing overbought and oversold areas)

 

Divergences

A divergence occurs when the MACD value diverges from price movement. Bullish divergence takes shape when price establishes a lower low and the MACD value prints a higher low. It is important to acknowledge that for price action, the focus is on closing prices, not candle extremes. Figure 2.B demonstrates bullish divergence. The lower low in price confirms the downtrend, yet the MACD’s higher low reveals decreased momentum to the downside.

Figure 2.B also shows bearish divergence, movement which has the currency pair record a higher high and the MACD value form a lower high.

Divergence does a good job of forecasting trend reversals or sizeable retracement/pullbacks; as such, divergence is considered a leading indicator.

However, divergences are by no means a guarantee price action will react. Divergence simply shows the trend’s momentum is slowing, but will, in the case of uptrends for example, continue to outpace downside momentum if the MACD value remains above the zero centreline.

Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 2.B: Source: MetaTrader 4 EUR/USD daily chart showing bullish/bearish divergence)

 

 

Histogram

As highlighted at the beginning of the article, the histogram represents the difference between the MACD value and the signal line. Therefore, the histogram is sometimes used to form divergence signals to help forecast potential bullish and bearish signal line crossovers.

  • The histogram registers a positive reading if the MACD moves above the signal line, and records a negative print in response to the MACD crossing below the signal line.
  • Histogram values increase/decrease if the MACD diverges further above/below its signal line and decreases/increases as the MACD and signal line converge.

Figure 2.C illustrates bearish divergence formed between two peaks on the histogram, essentially warning a MACD signal line crossover to the downside may be on the cards, which did eventually occur. Figure 2.D shows bullish divergence between two histogram troughs, which, in this case, forecasted a MACD signal line crossover to the upside.

In addition to using the histogram’s peaks and troughs, traders also use individual bars as the histogram moves towards the centreline to form divergence signals.

Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 2.C: Source: MetaTrader 4 EUR/USD daily chart showing MACD histogram bearish divergence)

Enhance Your Understanding of the MACD Indicator, FP Markets

(Figure 2.D: Source: MetaTrader 4 EUR/USD daily chart showing MACD histogram bullish divergence)

Trading the MACD

The MACD is considered a top-tier indicator.

The Majority of traders, however, do not trade solely on the back of the indicator’s signals, as the MACD is often used as a confirmation tool.

An example is price testing support—a level which has withstood a number of downside attempts—confirmed by a MACD bullish divergence signal.

Irrespective of how you employ the MACD, you must ensure the trading system is fully tested under different market conditions. This is where a demo account is useful, a simulated practice account using live price data.

Feel free to test-drive FP Markets demo account on MT4 or MT5, an established broker that’s been regulated since 2005.

  • Enhance Your Understanding of the MACD Indicator, FP Markets
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