Everything You Need to Know About MACD

Moving average convergence divergence was invented in 1979 by Gerald Appeal. It is one of the most popular technical indicators in trading. The MACD is appreciated by traders the world over for its flexibility because it can be used either as a trend or momentum indicator.

The concept behind the MACD is fairly straightforward. Essentially, it calculates the difference between an instrument's 26-day and 12-day exponential moving averages.

Of the two moving averages that make up the MACD, the 12-day exponential moving average is obviously the faster one, while the 26-day average is much more slower. In the calculation of their values, both moving averages use the closing prices of whatever period is mean the chart, a nine-day exponential moving averages of the MACD itself is plotted as well, and it acts like a trigger for buy and sell decisions. The MACD generates a bullish signal when it moves above its own nine-day exponential moving averages, and it shows a sell sign when it stays below.

The MACD histogram is an elegant visual representation of the difference between the MACD and its nine-day EMA. The histogram is positive when the MACD is above its nine-day EMA and negative when it stays below . If prices are rising, the histogram grows larger as the speed of the price movement accelerates, and contracts as price movement decelerates. The same principle works in reverse as prices are falling.

The MACD histogram is the main reason why so many traders rely on this indicator to measure momentum, because it responds to the speed of the price movement. Indeed, most traders use the MACD indicator more frequently to gauge the strength of the price move than to determine the direction of a trend.

As we mentioned earlier, trading divergence is a classic way in which the MACD histogram is used. One of the most common setups is to find chart points at which price makes a new swing high or a new swing low, but the MACD histogram does not, indicating a divergence between price and momentum.

Unfortunately, the divergence trade is not very accurate sometimes。 Prices frequently have several final 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 demonstrates a typical divergence fakeout, which has frustrated scores of traders over the years.

One of the reasons that traders often lose with this set up is they enter a trade on a signal from the MACD indicator but exit it based on the move in price. Since the MACD histogram is a derivative of price and is not price itself, this approach is, in effect, the trading version of mixing apples and oranges.
To resolve the inconsistency between entry and exit, a trader can use the MACD histogram for both trade entry and trade exit signals. To do so, the trader trading the negative divergence takes a partial short position at the initial point of divergence, but instead of setting the stop at the nearest swing high based on price, he stops out the trade only if the high of the MACD histogram exceeds its previous swing high, indicating that momentum is actually accelerating and the trader is truly wrong on the trade. If, on the other hand, the MACD histogram does not generate a new swing high, the trader then adds to his initial position, achieving a higher average price for the short.

Currency traders are positioned to take advantage of this strategy because under this strategy, the larger the position, the larger the potential gains once the price reverses -

and in Forex (FX), you can implement this strategy with any size of position and not have to worry about it influencing the prices. (Traders can execute transactions as large or as little as they want for the same typical spread of three to five points in major pairs.)

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