The MACD indicator is revealed in a big way! Can you be a prophet of trend forecasting?

What is MACD？

The Moving Average Convergence Divergence (MACD) is a technical indicator that simply measures the relationship of exponential moving averages (EMA). The MACD displays a MACD line (blue), a signal line (red), and a histogram (green) - showing the difference between the MACD line and the signal line.

The MACD line is the difference between two exponentially leveled moving averages – usually 12 and 26-periods, whilst the signal line is generally a 9-period exponentially smoothed average of the MACD line.

These MACD lines waver in and around the zero line. This gives the MACD the characteristics of an oscillator giving overbought and oversold signals above and below the zero-line respectively.

What does MACD measure？

The MACD measures momentum or trend strength by using the MACD line and zero line as reference points:

When the MACD line crosses ABOVE the zero line, this signals an UPTREND

When the MACD line crosses BELOW the zero line, this signals a DOWNTREND

In addition, the MACD signals buy or sell orders which are given when the two MACD lines cross over as outlined below:

When the MACD line crosses ABOVE the signal line, traders use this as a BUY indication

When the MACD line crosses BELOW the signal line, traders use this as a SELL indication

How is MACD calculated？

Most charting platforms offer the MACD indicator and implement this calculation using the aforementioned default periods. The formula below breaks down the varying components of the MACD to make it comfortable for traders to apply.

As mentioned previously, the MACD histogram plots the difference between the two moving average lines. The histogram fluctuates in and around the zero designation on the MACD indicator. When the MACD line is above the signal line, then the histogram will be positive. The opposite is true when the MACD line sits below the signal, whereby the histogram will plot below the zero as a negative value. A zero value on the histogram indicates a crossing over of the two moving average lines thus marking buy/sell signals.

Limitations of MACD

The MACD indicator is considered to work best in trending markets. This limits its use for traders depending on their trading strategies. For example, range-bound/consolidating markets will generally give flawed signals when using the MACD. Traders will need to truly understand MACD as well as when to employ the indicator for optimal use. Novice traders may find this indicator difficult to use initially, which is why going through the basic moving average and EMA fundamentals will benefit traders who are looking to make use of the MACD indicator.

The variations that can be implemented with the MACD indicator are almost infinite, which makes it very personal to the trader. This subjective nature of the MACD will mean that results differ from trader to trader, which takes away any consistency. Traders will need to follow a basic outline when using the MACD:

Selecting EMA parameters

Using an appropriate time frame, as MACD may function differently across time frames

MACD Indicator: A Summary

The MACD is unique in that it serves as an oscillator as well as a MACD crossover indicator. This dual purpose gives two signals in one indicator allowing for a less cluttered chart. Traders may find this useful, which makes understanding MACD worthwhile.

Become a Better Trader with Our Trading Tips

Learn about other oscillators and indicators to enhance your trading for both beginner and experienced traders:

Relative Strength Index (RSI)

Exponential Moving Average (EMA)

Simple Moving Average (SMA)

Technical traders have different styles and forex trading strategies. Explore these thoroughly to find out if this type of analysis suits your personality

OVERBOUGHT VS OVERSOLD

These two terms actually describe themselves pretty well. Overbought defines a period of time where there has been a significant and consistent upward move in price over a period of time without much pullback. This is clearly defined by a chart showing price movement from the “lower-left to upper-right” like the chart shown below.

LEARN FOREX: USD/CAD HOURLY CHART – OVERBOUGHT

The term oversold illustrates a period where there has been a significant and consistent downward move in price over a specified period of time without much pullback. Essentially, a move from the “upper-left to the lower-right” – see chart below.

LEARN FOREX: AUD/JPY WEEKLY CHART – OVERSOLD

Since the price cannot move in one direction forever, the price will turn around at some point. Currency pairs that are overbought or oversold sometimes have a greater chance of reversing direction however, could remain overbought or oversold for a very long time. Therefore, traders need to use an oscillator to help determine when a reversal could occur.

OVERBOUGHT OVERSOLD INDICATOR READINGS WITH RSI

There is a quick tool traders can use to gauge overbought and oversold levels, the Relative Strength Index (RSI). The premise is easy. When RSI moves above 70, it is overbought and could lead to a downward move. When RSI moves below 30, it is oversold and could lead to an upward move.

RSI OVERBOUGHT AND OVERSOLD LEVELS:

Traders need to be patient before entering trades using the RSI as on occasion the RSI can stay overbought or oversold for a prolonged period as seen on the chart below. A common error made by traders is attempting to pick a top or bottom of a strong move that continues to move further into overbought or oversold territory. The key is to delay until the RSI crosses back under the 70 or over the 30 as an instrument to enter.

RSI PROLONGED OVERBOUGHT AND OVERSOLD SIGNALS

The image above shows the RSI clearly breaking above the 70 level resulting in an overbought reading, but a seasoned trader will not look to immediately sell because there is uncertainty as to how far the price could continue to rally. Traders ideally will wait until the RSI falls back below 70 and then place a short trade. This gives a better entry and a higher probability of trade. When the RSI falls below 30, same rules apply.

FREQUENTLY ASKED QUESTIONS (FAQs)

How reliable are overbought and oversold signals？

Overbought and oversold signals as solitary signals are not entirely reliable. Think of building a house; a builder is reliant on a hammer but as an isolated tool, the hammer is worthless when building an entire house. Other tools will be needed in conjunction with the hammer for construction – a saw, drill, etc. The same concept relates to overbought/oversold signals which require complementary tools to strengthen the signal, and eventually allow traders to make sound trade decisions. For example, trend identification, risk management, and sentiment are useful tools that help complement overbought and oversold signals.

What can traders do to strengthen/support overbought and oversold signals？

Several common tools can be used to complement overbought and oversold signals. Below is a list of tools that can enhance your trading decisions:

Identify the trend – Filtering for the trend can aid traders in selecting entry points using overbought and overbought signals. For example, in an uptrend traders will filter for oversold signals as ‘long entry’ points which correlate to the direction of the trend. The opposite will apply to a downtrend.

Risk management – Using proper risk-reward ratios which relate to stop and limit levels should be adhered to.

Sentiment- Utilize client sentiment data to further verify overbought and oversold signals.