Despite sounding fairly complex, this type of technical analysis is actually accessible to all types of traders. Experts can dive into its nuances and make judgement calls on the price movements of forex pairs. Novices can use MACD charts to quickly spot potential trends as markets move from bullish to bearish and vice versa.
Naturally, there are no guarantees with this type of analysis. However, if you can learn the basics and use MACD as part of an overall strategy, it can be an extremely useful tool. This guide tells you everything you need to know about Moving Average Convergence Divergence. So, if you’re ready to add another skill to your forex trading arsenal, take a look at the sections below.
What is MACD?
MACD stands for Moving Average Convergence Divergence. It’s a technical indicator that’s used in trading, mainly forex, to measure the relationship between Exponential Moving Averages (EMAs). Before we dive further into the details of MACD, it’s important to explain what EMA means. For those that have read our other guides, particularly about Bollinger Bands, you’ll have come across the term Simple Moving Average (SMA).
An SMA tracks the average price of an asset over a specified period of time e.g., 20 days. You obtain the SMA of an asset by adding up its recent prices and dividing by the number of datapoints used. EMA is a derivative of SMA. In simple terms, it provides a data line that’s based on price averages. However, the main difference between EMA and SMA is that EMA places more emphasis on recent price movements. Therefore, EMA is more responsive to and reflective of current fluctuations.
MACD builds on EMA. What you get when you plot MACD lines on a chart is a picture of the relationship between EMAs. To put it in layman’s terms, this is a trend-following indicator that shows the relationship between two moving price averages i.e., how two EMAs compare to each other over a period of time.
How Does MACD Work?
Now we know what MACD is and what it measures, let’s delve a little deeper into this technical indicator and how it can help you trade forex in a better way. We’ve said that, in general, MACD measures the relationship between EMAs. To be more specific, it looks at two exponential moving averages within a 12-period and a 26-period. These two figures are important as they’re what’s used to calculate MACD using the following formula:
MACD = 12-Period EMA − 26-Period EMA
This formula says that you can calculate the MACD by subtracting the long-term EMA (26 periods) from the short-term EMA (12 periods) when it’s written out in plain English. Something else to note before we continue is the use of the word period. In this context, a “period” is a set amount of time e.g., a week, month, quarter, etc. So, you could have EMAs with weekly periods. That means you’d have an EMA value for 12 weeks and an EMA for 26 weeks. You’d then subtract the former from the latter to get your MACD.
Once you’ve got that, you can calculate a nine-day Exponential Moving Average (EMA) for the MACD. This gives you the “signal line”. That gets plotted on top of the MACD line and acts as a trigger for buy/sell orders. Basically, once you’ve got a signal line, movements above or below it will signal different things:
- A movement above the signal line suggests that assets could be moving into a bullish trend. If that’s the case, it may be worth buying.
- If the price of the asset drops below the signal line, it could be moving into a bearish trend. If that’s the case, it could be time to sell (go short).
Should You Choose MACD As Your Forex Trading Strategy?
MACD is a great technical indicator in forex, but it shouldn’t be the only tool in your toolbox. What’s more, it may not be right for your style of trading. To help you decide whether or not this indicator is for you, here are some advantages and risks of MACD analysis.
The Advantages of MACD
MACD charts contain three lines: the Blue MACD line, the Red Signal Line, and the Green Histogram. When the blue crosses the red in an upwards movement, it signals a bullish movement and vice versa. Forex traders like this set up because it’s easy to spot short-term movements i.e.
- An upwards crossing point = bullish
- A downwards crossing points = bearish
Given that forex trading is fairly high-paced, having the ability to quickly spot potential changes is great.
Another benefit of using MACD is that it can show when momentum is building in a certain direction. As we’ve said, this type of analysis looks at the relationship between EMAs. When these EMAs converge, it means the MACD must be equal to zero. When a convergence happens, you can plot a centreline (a zero line). This indicator can help you identify the direction of a trend and when momentum is moving in a certain direction.
The Risks of MACD
The main drawback to MACD is that it can throw up false positives or false negatives, depending on your perspective. Because of how values are calculated, there can be some lag when prolonged price movements occur. For example, the price of a currency pair may be switching from bullish to bearish over the course of a week. However, before the market finally pivots, there may be some mini ups and downs. MACD may cause you to buy/sell unnecessarily during these times.
In essence, the short-term focus of MACD is great, in general. But there will be times when it fails to capture the full scope of what’s going on. In technical terms, you could whipsaw in and out of positions before a strong pattern has emerged. Therefore, while this is a great tool to use when you’re trading forex, it should form part of bigger strategy. By considering other technical indicators, as well as subjective data points, you’ll stand a better chance of avoiding unnecessary and, potentially, incorrect short-term moves.
Why Do Traders Use MACD?
Forex traders use MACD to determine when it’s best to open or close a position based on average price movements. As we’ve noted, there is some lag with this type of technical analysis and that can cause you to make unnecessary moves or miss certain pivot points.
However, overall, this is a great way to look for shifts in momentum. Again, when the MACD line goes above the signal line, it suggests a bullish trend that’s worth buying into. When the MACD line goes below the signal line, it suggests a bearish trend where short positions become attractive. Keep those rules in mind and you’ll give yourself a better chance of making better predictions.
How to Use MACD as Part of Your Forex Trading Strategy?
You can implement MACD into your forex trading strategy by following these simple steps:
- Take a look at our online broker reviews. Find one that suits your needs and use our secure sign-up links to create your first (and only) account.
- Verify your new account and make a deposit on the broker’s site.
- Install your preferred trading platform/the platform offered by the broker (this could be MetaTrader 4, for example).
- Find a currency pair and go to the Tools option.
- Activate the MACD option to plot a chart for your chosen forex pair.
- Review the data and start trading.
Use MACD for Online Forex Trading
Like all technical analysis tools, MACD isn’t the one and only option. However, it’s a great way to spot changes in momentum. In fact, what’s useful about this type of analysis is that you don’t have to be an expert to use it. Understanding the nuances of a trading tool is important but it isn’t always necessary. That’s the case with MACD. As long as you can spot the MACD (blue line) and signal (red line), you can read these charts.
Once the blue line goes above the red line, it suggests there’s a bullish movement. If it goes below the red line, it suggests there’s a bearish movement. These are the two main things you need to keep in mind. They shouldn’t be the only indicators you use, but they are a great way for experts and novices to spot trends. That’s why you should use MACD as a forex trader.