How To Trade Forex Using The MACD Indicator
Introduction
When it comes to trend following and momentum trading, there are many indicators and tools available on the market, but there are few as popular as the MACD (pronounced by most as MACk Dee).
In this article, we are going to have a look at what MACD is, how to add the MACD indicator to your chart and how to use MACD when trading Forex.
What is the MACD
MACD stands for Moving Average Convergence – Divergence.
It was developed by Gerald Appel in the 1970’s and provides both trend-following and momentum information. The standard MACD indicator supplied in MT4 consists of a histogram (a bar chart) and a signal line. The MACD line is the outer profile of the histogram and is calculated by subtracting one moving average from another.
The signal line is an exponential moving average based on the MACD line.
On a chart, the primary MACD line fluctuates above and below a zero line and converges (moves towards), crosses and diverges (moves away) from the signal line over time.
Figure 1 above shows a EURUSD daily chart with the standard MT4 MACD applied.
You can see the MACD histogram shown in magenta and the MACD signal line shown in blue. The settings for this chart are the standard default settings of 12, 26, 9. The MACD histogram is the difference between 12 bar moving average and the 26 bar moving average.
The MACD signal line is the 9 bar exponential moving average of the MACD line.
Some zero line cross overs have been marked on the chart, shown as vertical orange lines. The histogram is positive and is considered bullish when above the zero line. Conversely, the MACD is negative and considered bearish when below the zero line.
Therefore zero line crosses are considered an indication of trend change, from bearish to bullish when crossing from beneath and bullish to bearish when crossing from above.
Attaching the MACD indicator to your charts is easy.
There is no configuration to be done, other than changing the settings if you desire, and it is attached in the same way as any other indicator. It’s easy to find, located under the ‘Oscillators’ folder in the list of indicators on your MT4 platform.
Step 1) Open MT4 on a chart you want to attach the MACD to.
Step 2) Open the ‘Navigator’ panel, either from the tab ‘View’, ‘Navigator’ or click the icon on the top panel which has a yellow folder with a gold star on it.
Step 3) Expand the ‘Oscillators’ folder and locate the MACD file
Step 4) Either double click on the MACD file or drag and drop the file onto your chart
Step 5) Change the settings or click colours tab and change the line colours and thicknesses of the histogram and signal lines and then click ‘OK’
And there you have it.
The MACD will now be at the bottom of your chart.
How to use MACD in Forex trading
There are really 3 main ways to consider using MACD in your Forex trading
1) Zero line crosses
2) Signal line crosses
3) Divergence
Zero Line crosses
We mentioned zero line crosses briefly above, but basically when the MACD line crosses the horizontal zero line, it is generally considered an indication of a trend change.
Have a look at figure 3 below.
Figure 3 shows the same EURUSD daily chart as in figure 1, except a 13 and 34 exponential moving average have been added to give some context to the trends.
Some green and red vertical arrows have also been added to highlight the direction of the MACD zero line crosses, which are derived from the MACD histogram.
As you can see, this section of chart action is showing a general uptrend with some higher highs and higher lows being printed. After the initial reversal in the bottom left of the chart we get our first bullish cross over as the MACD histogram goes from below to above the zero line, also highlighted by the first green arrow.
During the first retracement, we get a bearish cross over before the EMAs bottom out and as soon as they turn upward, we get our next bullish zero line cross and the uptrend takes off again with some strong momentum.
The second retracement is longer and deeper this time, but again as price reverses and rallies upwards again, so do the EMAs and we immediately get our 3rd bullish zero line cross. This example shows how the MACD zero line crosses can be useful indications of trend changes and trend direction.
You can also see that the stronger the momentum and the stronger the trend, the larger the histogram hills are. They develop more fully and more quickly.
The last uptrend rally is relatively weak in comparison to the second and this is reflected in the lower hills which appear more deflated and less forceful in appearance.There are other points to cover in this example, so let’s look at the second use for MACD – using the signal line and signal line crosses…
Signal line crosses
The degree of separation between the MACD line (histogram outer profile) and the signal line is related to momentum.
When the two lines are moving apart i.e. diverging, the MACD line is pulling away from the signal line indicating that the bullish or bearish momentum is becoming stronger.
When bullish momentum weakens sufficiently, and bearish momentum starts to pick up, we get a MACD signal cross over.
This is demonstrated in Figure 4 below.
Each of the black circles in figure 4 highlights a MACD signal line cross over.
At circle 1, price is making a reversal and the MACD histogram crosses and instantly diverges from the signal line as strong bullish momentum exists. As price reaches the 34 EMA from below, it puts in a short correction and you can see the histogram pulls back towards the signal line as the recent upward momentum corrects.
As price reverses after the correction, we get the zero line cross and price climbs sharply, the MACD histogram again pulling away from, diverging from, the signal line.
After the next minor correction back to the 13EMA, we see that even though price is still climbing strongly, the MACD histogram and signal line converge, indicating that the bullish momentum is subsiding, until at circle 2, we see a bearish MACD histogram/signal line cross and price falls sharply downwards to the 34 EMA and beyond.
The MACD falls just below the zero line before we again get a bullish MACD / signal line cross at circle 3, followed by a zero line cross and EMA cross at the same time. This all indicates that bullish momentum is again in control and price powers upwards with great separation between the histogram and signal lines.
At circle 4, we get an abrupt end to the bullish buying momentum and even though price continues to make a final high, we have already seen a strong bearish MACD/signal line cross, warning of an imminent price reversal.
Price falls away sharply in a deep retracement before bearish momentum slows and although price continues to fall, we get a bullish MACD/signal cross at circle 5.
When selling finally finishes, price reverses once again, as indicated and climbs quickly above the 2 moving averages to continue the uptrend.
Shortly after, price corrects back to the 34 EMA which takes the wind out of the bullish momentum and we see a bearish cross at circle 6, after which price continues to climb upwards but with much reduced momentum.
It can be seen from these examples that MACD / signal crosses are NOT buy/sell indicators or triggers. They indicate that a reversal of some kind is imminent, but in strong buying or selling markets, that reversal could take some time to materialize.
Like all oscillators, they can remain in extended overbought and oversold conditions for long periods in strong trends. You may have made money on the first three crosses, but due to the MACD divergence occurring after the crosses at circles 4, 5 and 6, you would most likely have been stopped out had you entered trades at the time of the cross overs.
This leads us nicely onto the third practical use of MACD in your Forex trading – the identification of divergence.
The EURUSD price chart used in the figures so far shows some great examples of all the main practical uses for MACD, including divergence. In this discussion about divergence, we are not talking about converging/diverging MACD/signal lines, we are talking about the phenomenon of divergence that most oscillators display.
From previous articles you may have read about what divergence is, but here is a quick recap. Bullish divergence is demonstrated when price continues to make lower lows, but the oscillator, in this case MACD, makes corresponding higher lows. Bearish divergence, on the other hand, occurs when price continues to make higher highs, whilst the oscillator, MACD, makes corresponding lower highs.
Divergence does not always lead to a full on key price reversal, but could also be signifying that a retracement in the trend is imminent.
Take a look at figure 5 below.
There are 4 great examples of MACD divergence in figure 5 above.
Starting with the price action labelled 1 on the chart, we can see that price has come down steeply to a point of reversal and to the start of the uptrend which exists for the next 6+ months on the chart. As price comes down and puts in the first low, MACD puts in a corresponding low.
As price corrects or retraces back slightly to the 13 EMA, reverses and continues downwards, the bearish momentum has noticeably slowed and as a result, as price puts in the next and lowest low, the MACD histogram puts in a higher low.
The difference in direction of the price low and the MACD low is called divergence. In this case, we have bullish divergence shown by the MACD, since it gives forewarning of a potential upturn and/or bullish price reversal.
As it happens, this was a significant turning point in the market and price did indeed reverse.
After a couple of strong phases of buying separated by a relatively minor correction, we arrive at divergence scenario 2.
There is considerable bullish momentum in the second phase of the uptrend, corroborated by the great separation between the MACD and MACD signal lines.
However, as price puts in a swing high and retraces back to the 13 EMA, we not only get a signal line cross, but as buying resumes, it does so without major buying pressure behind it and consequently, as price puts in the peak high/highest high, MACD puts in a much lower, lower high, giving a clear indication of bearish divergence, after which price reverses and makes a major price correction.
As the major sell off progresses, price prints a swing low before correcting back to the 34 EMA and then continuing downwards but with visibly less conviction and again, this results in clear divergence (3) with MACD printing successive higher highs, until finally the bulls resume buying interest again and price makes a significant reversal, climbs above the EMAs and continues the bull run once again.
However, after initial strong buying interest, momentum wanes and yet again we see higher price highs at 4 with lower MACD highs.
You can see that the first two divergent situations resulted in immediate and significant price reversals, whereas in the third case, it took a lot longer before price finally reversed.
However, it is the case that in this chart example, all divergence led to price reversals.
The higher the timeframe, the more significant the appearance of divergence becomes. For instance, a reversal on the daily chart, such as the one used throughout this article, produces sustained price action for a good period of time. The divergence that occurs on this chart and on the daily timeframe is far more likely to create sustained reversals or corrections.
Even corrections on a daily chart can be significant reversals on an H1 chart, since 10 days in one direction on the daily chart is only 10 bars, but on an H1 chart it is 240 bars representing a complete up or down trend in it’s own right.
That is why timeframe perspective and a larger viewpoint is always important.
Hopefully this article has given you a good introduction to MACD.
You have learnt what MACD is, how it is applied it to a chart in MT4, what the main features are and how MACD can be used to assist you with your Forex trading.
Unlike some other indicators, MACD is not a buy/sell signal generator and should not be used as such. The zero line crosses do give a good indication of trend direction change, but it is just that, indication.
From that point on, if good momentum exists, you would be looking for appropriate buying/selling opportunities in the new direction of price and momentum. If price remains above the zero line, then continued buying can be expected until divergence shows up or you get a MACD signal line cross to the downside.
Equally, if price remains below the zero line, then continued selling can be expected until divergence shows up or you get a MACD signal line cross to the upside, which would be your cue to wait for further information.
The MACD signal line crosses give a good indication that momentum has shifted in the other direction, either through reduced buying/selling pressure in the existing direction or by increased buying/selling pressure starting to mount in the opposite direction.
But signal line crosses themselves are NOT buy/sell signals.
They are an indication of a change of sentiment in the market. In strong and extended trends, you may get several signal line crosses, but this is a function of price running for long continued periods with little momentum and market resistance.
Look out for this and don’t react impulsively if you see it.
Think about what it means.
The indication of divergence is important information to a momentum / trend trader, since the mere presence of divergence is a reason to stop buying or selling in the original direction, take partial or all profits and wait for signs of reversals.
Regardless of whether it turns out to be a full scale price reversal or merely a price correction or retracement is immaterial.
Price may never reach the highs or lows at which it is prior to the reversal or retracement, so being forewarned is of immense value to a trader.
There is not much a trader can predict about price, so any hints or indications that might suggest otherwise can and should be used wisely and to good effect. As with all indicators and trading tools, MACD should never be used in isolation and as we have seen, even combined with just a couple of EMAs it gives the MACD signals more context.
Remember, always trade what you see, not what you think!