The MACD is another popular technical indicator that many people use to successfully trade the Forex market. The term itself is an acronym for Moving Average Convergence Divergence and was designed in 1979 by famous market technician Gerald Appel.
The MACD has a number of different uses, which means traders use it in many different ways with some using it incorrectly. It can be used to measure momentum, find divergence, as a trend indicator, and it can be combined effectively with many other indicators.
The MACD indicator functions by calculating the difference between two moving averages — typically the 12-day exponential moving average and the 26-day EMA. This difference is then presented using two lines that represent the moving averages of the difference, and a histogram.
It is the histogram that shows the difference between the two lines and therefore whether the market is diverging or converging.
Luckily, you do not have to do those calculations manually. Your currency trading software, such as MetaTrader, will handle the whole calculation process for you.
Although it sounds simple enough, many traders make the mistake that the lines on the MACD represent the moving averages of the price but this is incorrect. The lines actually mark the exponential moving averages of the difference between the two exponential moving averages. It is a subtle distinction, but it does allow a more effective prediction of where the market is going.
One way to use the MACD indicator is using a crossover strategy, and this is probably the most popular method used by traders.
Essentially, a trader will watch the two lines on the MACD and when the fast line crosses over the slower line, he or she will likely buy. This is because the crossover signals that the faster average is diverging from the slower average at a fast rate and thus a new uptrend has just begun. Conversely, a trader will likely sell when the fast average crosses under the slow average since the market is now converging.
When a crossover takes place, the histogram will show a figure of zero since there will be no difference between the averages at this point. Thus, the histogram can also be watched to signal crossovers.
Another way to use the MACD indicator (and possibly a more effective solution) is using the momentum and divergence strategy. This strategy allows the MACD to act as a relative strength indicator and can also be combined effectively with other indicators.
Let us imagine that the FX pair EUR/USD is in a long-term upward trend and has just made one of a number of new highs. Looking at the MACD indicator we can make a judgment on the strength of the move and decide whether a reversal is likely to occur in the near future.
If, for example, EUR/USD has made a new high, but the MACD indicator has not made a new high, we can say that although the market is up, momentum could be slowing. Even more, if we look at the MACD and the faster average is moving back towards the slower average, we can clearly say that the market is converging. I.e., the faster average is moving up at a slower rate. This is a strong signal that the market will be near a top and a trader should sell. This strategy is exactly the same, but reversed, for downtrends.