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– USD/CAD

 

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.

Trading MACD divergence is often a long-term strategy. It is not uncommon for prices to 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. Stop-loss placement is critical to the success of trader’s who rely on MACD divergence as the basis for their strategy. Knowing when trends are about to reverse is tricky business, learn more about spotting the trend in Spotting Trend Reversals With MACD.)

One of the primary reasons that traders often lose money when using divergence as a trading signal is because they enter a position based on a signal from the MACD, but find themselves in the position of 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?)

 

U.S. Dollar

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