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Friday, December 28, 2007

MACD Moving Average Convergence Divergence

The MACD Developed by Gerald Appel, Moving Average Convergence/Divergence (MACD) is one of the simpler, more reliable indicators available. The MACD uses moving averages, which are momentum indicators and therefore lagging indicators that include trend-following characteristics. Our main priority in trading is to find the trend and trade with it, because that is where the most money is made.

There are 3 figures used to calculate a MACD

The first is a fast moving average. The second is a slower moving average. The third calculation is represented by bars and is the difference between the faster and slower moving averages.
For example, a standard MACD setting on most charting packages is (12,26,9) We interpret them as follows.

12 Represents the previous 12 bars or candles of our faster moving average.
26 Represents the previous 26 bars or candles of our Slower moving average.
9 Represents the previous 9 bars of the difference between the two moving averages. This is shown as vertical lines (Blue on Chart)called a histogram.

I am not going to try and describe the maths for the exact calculation as your charting package does it automatically for you. Suffice to say, these lagging indicators become a momentum oscillator when the longer moving average is subtracted from the shorter moving average. This results in a line that oscillates above and below zero, without any upper or lower limits. Theoretically we buy above the zero line and sell below the zero line. The histogram is bullish when MACD is above its 9 bar MA and Bearish when it is below its 9 bar MA. When the bars start to get longer on the histogram we call this divergence (diverging away from the MA). As the bars get shorter we call this convergence, (converging towards the MA) As the momentum of price increases or decreases the histogram bars grow longer or shorter. (MACD)

Trading the MACD.
When the faster MA crosses the slower MA and the histogram bars form above or below the zero line it often indicates the start of a new trend as the faster MA diverges away from the slower MA.
As we can see from the above 1hr usdchf chart the bars started to converge from the bearish position below the zero line until they crossed the Zero line signalling a possible entry to go long.

Because the MACD is made up of moving averages of other moving averages, further smoothed by another moving average there is generally a fair amount of lag in signalling the new trend. We see from the above chart that price had rallied almost 100 pips from the low before the MACD confirmed the trend change.

On the next chart above I have added faster period MA's 5, 13, 8, to the MACD settings. The first vertical red line shows the Zero cross about 50 pips earlier than the 12, 26, 9, setting. Once again we have a trade off between more sensitive earlier entries with possible false signals and less sensitive later entries with the possibility of missing the trade completely or getting caught going the wrong way because of the greater lag.

Only by back testing and playing with the settings for your time frame can you find a MACD that you are comfortable trading.

As we can see from the next chart price had dropped 100 pips before the 5, 13, 8 MACD with the faster settings signalled a possible short below the Zero line only to have a reversal and get caught going the wrong way.
The slower MACD did not cross below Zero, neither did it confirm the down move. In the first instance the earlier entry on the faster MACD would have made us a larger profit but the second trade we would have lost the extra we made by entering the market in the wrong direction. Using other indicators in conjunction with our MACD can help with confirming our entries and avoiding false signals. The MACD However remains a firm favourite with many traders.
The MACD is also commonly used to identify divergence in the market which we will look at later.
  • The MACD is calculated using 3 different moving averages.
  • The MACD is a lagging indicator.
  • The MACD is a trend indicator mainly used to enter the market.

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