| Moving Average Convergence Divergence - MACD. |  |
Commander in Pips: The next indicator that we will talk about is Moving Average Convergence Divergence, but it better known as MACD. So, we will refer to it in that way – MACD. Besides, you will understand this indicator more easily, because you are familiar with MAs already and MACD is based on them.
Commander in Pips: Well, there you are.Pipruit: Yes, I’ve understood MAs well, at least better than your Bollinger Bands…
Description of MACD Indicator
The major task for using MACD is estimation of trend direction. Personally, this is my favorite indicator for that purposes. Also MACD could be used for some specific price behavior identification, such as bullish/bearish divergences and market Dynamic Pressure. But this is a bit advanced for now and we will talk about those uses in later chapters. Today our task is the basics of MACD.
As we said, MACD was born for trend identification – it extremely important for us, because trading with the trend is a primary task for any trading plan.
MACD could be plotted on the chart two ways – with two crossing lines overtime, or as Histogram.
Chart #1 60-min EUR/USD and MACD (12; 26; 9)
This indicator has three input parameters:
1. Period for fast MA – let’s call it MA1. Usually in most software programs it has a value of 12 as default;
2. Period for slow MA - let’s call it MA2. Usually in most software programs it has a value of 26 as default;
3. Period for MA that averages and smooths difference between two previous ones - let’s call it MACDA (MACD Average). Usually in most software programs it has a value of 9 as default.
Commander in Pips: Yes, but Lines of MACD that you see on the chart are not just the MAs that we’ve specified. If it will be so, then why we should use it – this is the same as a simple MAs. What’s the difference?Pipruit: Wait a minute – you’ve said that it consists of two lines, but here we have three…
Commander in Pips: Look how it works:Pipruit: And so what are the lines then?
1. The fast line of MACD indicator calculates as difference between MA1 and MA2:
MACD (line) = MA1-MA2.
This is the first line that you see
2. The second line that is slower is a moving average that calculates using MACD (line) – that difference between MA1-MA2. Other words it plots average difference between MA1 and MA2. And by appointing some parameter for MACDA – you exactly appoint number of such differences that will be averaged by this third line:
MACDA = Moving average on (MA1-MA2).
That’s the second line.
Although those two lines look like a simple MA crossing – the way of calculation gives significant advantages when you apply MACD.
Commander in Pips: Absolutely.Pipruit: Sounds a bit complicated. So, the first line is a simple difference between two MAs that we’ve specified in the parameters of the MACD indicator. Speaking in terms of default settings – this is “26-period MA – 12-period MA”. So, software calculates the value for 12-period MA, then it calculates value for 26-period MA and finally calculates the difference between them and particular this difference we see as the first line of MACD Indicator right?
Commander in Pips: That’s right.Pipruit: Well, then. The second line is calculated by software using the same formula of Moving Average calculation. But instead of using close prices as it was in previous part 11 of book, it uses values of (MA1-MA2) during the number of periods that we’ve specified. So, using the same default settings, this line plots average value of (MA1-M2) for 9 periods. So, this is the second line, a?
Commander in Pips: And now is my turn to ask questions. Why in the first line we should calculate MA1-MA2, and not MA2-MA1?Pipruit: Cool. Looks like, I’ve got it!
Commander in Pips: You’re absolutely right.Pipruit: May be I’m wrong, but it reminds me the simple strategy of two MAs crossing, that we’ve already discussed. When fast line (with shorter period) crosses slow line (with longer period) from below and comes above – the trend turns bullish and vice versa. Since MA1 is faster than MA2 –it reacts faster on trend shifting. That’s why we use MA1-MA2, and not opposite.
Commander in Pips: Oh, yes – some software names third MA, that is MACDA and that has 9 periods as default, as Signal Line. This is slower line, and signal of trend shifting will appear when first line penetrates it. That’s why it calls like that. So:Pipruit: Commander and what is a “Signal Line”?
1. Fast line of MACD (usually colored with blue) – MA1-MA2 that you appoint in indicator tweak menu;
2. Slow line of MACD, aka Signal Line (usually colored with red) – MA on (MA1-MA2).
Now is about plotting MACD as a Histogram. Histogram shows the distance between MACD lines – that’s all. So, when the lines come close to each other, i.e. converge – the histogram gets smaller and it’s bars are shorter. That’s correct, because the distance between the lines becomes smaller. And it is called convergence of moving averages.
The opposite is also true – when the distance between lines becomes wider, i.e. lines diverge from each other – the histogram gets bigger, and it is called divergence of moving averages.
Here is the name – Moving Averages Convergence Divergence!
Application of MACD
Trend identification
As we’ve said, MACD has two MAs with different speed. As we already know the fast MA (with smaller period) will faster react on appearing of new trend and outstrip the slower MA in following to trend. Hence – fast MA will cross slower MA. Actually, the way of interpreting MACD is the same as simple MA crossing.
When such crossover has happened and the fast MA starts to diverge from the slower one, it indicates that a new trend has appeared:
Chart #2 60-min EUR/USD and MACD (12; 26; 9)
On chart #2 you can see, that line crossing nicely point on starting bull trend, and on bear trend then. So, the crossing of the fast line (blue) of the slow line (red) from below and moving above – indicates that the trend has shifted to bullish. If the fast line crosses the slow line from above and moving below –the trend turns bearish.
Also take a note, that when the lines cross – the histogram disappears. This happens, because the difference between the lines equal to zero at the moment of crossing – hence the value of the histogram is also zero. But after that, when the distance between lines starts to increase – the histogram becomes greater and this is a good indication of a solid trend.
But, as with any tool MACD has its own bugs. I intentionally draw the rectangle on the chart. Does it remind you anything? Pay attention to signals that MACD generates during this rectangle and match them with price action…
Commander in Pips: You’re rights. Since MACD has much common with simple moving averages – it has the common disadvantages with them as well. That’s why it tends to lag behind the price…Pipruit: Well-well, looks like we have here whipsaw price action, do we? I can’t guarantee the financial result of trading here, but the fact that MACD is too slow in estimating fast and short-term trend shifts is obvious.
Commander in Pips: But still, it is one of the most favored tools amongst the traders, including me. Personally I use only MACD for trend identification, but in a bit of an advanced manner. For now we will talk how to reduce the negative impact of MACD lagging to trend identification.Pipruit: I do imagine – MACD is not just a simple MA – this is a Moving Average of a Moving Average… So, there is no surprise that it has a lag…
Fine Tuning of MACD and some advanced talks
1. The type of MAs that are used in MACD indicator do make sense!
You have to know that MACD could be different in different software programs. As many software programs as many different combinations of MA types they use in MACD Indicator. Usually MA1 and MA2 are Exponential and the Signal line is simple MA. Personally I prefer to use the exponential way of averaging for all lines in MACD Indicator;
2. As with any other indicator MACD demands a responsible approach to using it. You should investigate what type of MAs averaging in MACD and what parameters of them are most suitable personally for you. Also you can apply different parameters to different pairs and time frames. Maybe it will make sense.
3. Usually trend shifting is treated as confirmed when the market confirms it by close price. It is important, because if you’ve entered long in the beginning of the current trading session and an unconfirmed trend was, say, bullish but when trading session has closed and the confirmed trend becomes bearish – so you will be on the wrong side of price action.
4. The angle of line crossing does make big sense. The greater the angle – the stronger the signal of trend shifting:
This is not necessary means that a weaker signal will lead to loss or choppy price action. Sometimes even a weaker signal could lead to a tremendous trend. But from a confidence and probability point of view – the greater the angle of crossing, the better.
5. MACD works much better if the market is in a thrusting move. If for instance, if the market has shown a nice thrust up (at least 8-12 bars), and then has turned to retracement down – then a MACD signal about continuation of the previous up move has more chances for success because it is supported by market momentum. When the market choppy and sloppy, without any signs of thrust – better not to trade here with MACD or any other trend indicators.
This is not necessary means that a weaker signal will lead to loss or choppy price action. Sometimes even a weaker signal could lead to a tremendous trend. But from a confidence and probability point of view – the greater the angle of crossing, the better.
P.S. This lesson was written by Sive Morten, who has been working for a large European Bank since April of 2000, and is currently a supervisor of the bank's risk assessment department. Sive's knowledge of forex market and banking industry is vast and quite complete. If you have any specific questions about forex, banking industry, or any other financial instruments, please post them below, we'll notify Sive, and get them answered within 1 week.
P.P.S. Sive Morten's primary focus is trading EUR/USD. If you wish to receive his FREE trade recommendations for EUR/USD, please subscribe here for free.
Note: FPA ranks are earned in the battles against scam, not in the classroom.
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