Forex Walkthrough

Level 4 Charts - MACD

The MACD is another popular tool many traders use. The calculation behind the MACD is fairly simple. Essentially, it calculates the difference between a currency's 26-day and 12-day exponential moving averages (EMA). The 12-day EMA is the faster one, while the 26-day is a slower moving average. The calculation of both EMAs uses the closing prices of whatever period is measured. On the MACD chart, a nine-day EMA of MACD itself is plotted as well, and it acts as a signal for buy and sell decisions. The MACD generates a bullish signal when it moves above its own nine-day EMA, and it sends a sell sign when it moves below its nine-day EMA.

The MACD histogram provides a visual depiction of the difference between MACD and its nine-day EMA. The histogram is positive when MACD is above its nine-day EMA and negative when MACD is below its nine-day EMA. If prices are in an uptrend, the histogram grows bigger as the prices start to rise faster, and contracts as price movement begins to slow down. The same principle works in reverse as prices are falling. Refer to Figure 1 for a good example of a MACD histogram in action.




Figure 1: MACD histogram. As price action (top part of the screen) accelerates to the downside, the MACD histogram (in the lower part of the screen) makes new lows.
Source: FXTrek Intellicharts
The MACD histogram is one of the main tools traders use to gauge momentum, because it gives an intuitive visual representation of the speed of price movement. For this reason, the MACD is commonly used to measure the strength of a price move rather than the direction or trend of a currency.

Trading Divergence
A classic trading strategy using a MACD histogram is to trade the divergence. One of the most common setups is to identify points on a chart where the price makes a new swing high or a new swing low but the MACD histogram doesn't, which signals a divergence between price and momentum. Figure 2 depicts a typical divergence trade.


Figure 2: A typical (negative) divergence trade using a MACD histogram. At the right-hand side of the price chart, the price movements make a new swing high, but at the corresponding point on the MACD histogram, the MACD histogram is unable to exceed its previous high of 0.3307. The divergence is a signal that the price is about to reverse at the new high and as such, it is a signal for the trader to enter into a short position.
Source: Source: FXTrek Intellicharts
Unfortunately, the divergence trade is not that reliable or accurate - it fails more times than it succeeds. Prices often have several final volatile bursts up or down that trigger stops and force traders out of position just before the move actually makes a sustained turn and the trade becomes profitable. Figure 3 illustrates a common divergence fakeout, which has frustrated many traders over the years. (Knowing when trends are about to reverse is tricky business, learn more about spotting the trend in Spotting Trend Reversals With MACD.)


Figure 3: A typical divergence fakeout. Strong divergence is illustrated by the right circle (at the bottom of the chart) by the vertical line, but traders who set their stops at swing highs would have been taken out of the trade before it turned in their direction.
Source: Source: FXTrek Intellicharts
One of the reasons that traders often lose money in this type of fakeout is because they enter a position based on a signal from the MACD but end up exiting it based on a move in price. Since the MACD histogram is a derivative of price and not a price itself, this approach mixes the signals used to enter and exit a trade, which is incongruent with the strategy.

Using the MACD Histogram for Both Entry and Exit

To resolve the inconsistency between entry and exit signals, a trader can base both their entry and exit decisions on the MACD histogram. To do so, if the trader was trading a negative divergence then he would continue to take a partial short position at the initial point of divergence, but instead of using the nearest swing high as the stop price, he or she can instead stop out the position if the high of the MACD histogram exceeds the swing high it reached previously. This tells the trader that price momentum is actually accelerating and the trader was wrong on the trade. On the other hand, if a new swing high isn't reached on the MACD histogram, the trader can add to his initial position, continually averaging a higher price for the short position. (Read more specifically about averaging up in our article Is Pressing The Trade Just Pressing Your Luck?)

In effect, this negative divergence strategy requires the trader to average up as prices temporarily move against him or her. Many trading books have called such a technique "adding to your losers". However, in this strategy the trader has a perfectly logical reason for averaging up - the divergence on the MACD histogram indicated that price momentum was waning and the movement may soon reverse. In effect, the trader is trying to call the bluff between the seeming strength of immediate price action and MACD readings that hint at weakness ahead. Still, a well-prepared trader using the advantages of fixed costs in FX, by properly averaging up the trade, can withstand the temporary pressures until price turns in his or her favor. Figure 4 demonstrates this strategy in action.


Figure 4: The chart indicates where price makes successive highs but the MACD histogram does not - foreshadowing the decline that eventually comes. By averaging up his or her short, the trader eventually earns a handsome profit as we see the price making a sustained reversal after the final point of divergence.
Source: Source: FXTrek Intellicharts

Trading forex is rarely black and white. Rules that some traders live by, such as never adding to a losing position, can be used profitably in the right strategy. However, a logical underlying reason should always be established before using such an approach. In the next section, we'll look at the fundamental speed strategy which bases trade decisions on fundamental economic data rather than technicals like the MACD histogram.


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