How to Use MACD in Forex Trading - MACD Divergence - MACD Convergence

Category: Technical Analysis | Wednesday, May 20th, 2009

MACD is one of the most reliable indicators. Although I do not believe in using indicators in my own trading and I always use the price candlestick chart to find the trade setups, I look at MACD direction when I find a signal on the price chart. So I use MACD as a confirmation and it really works for me.

Why MACD works?

This is a million dollar question. Before I answer this question that why MACD works, I prefer to explain about one of the most important reasons of forex traders’ (and also all other kind of traders’)failure. Maybe you have heard this a lot from us but it has to be reminded in this article too. Lack of patience is one of the most important reasons of forex traders failure. Most traders are not patient enough to wait for a good trade setup. After several minutes, hours or days that they wait for a signal (depend on the time frame or system they use), and they can not find any signal, they lose their patience and force themselves to take a position while there is no sharp and clear signal. So they lose. On the other hand, when they succeed to take a good position, they get out too early with a small profit because they are afraid of losing the profit they have already made. They do not have enough patience to hold a position until it hits the target. So they make their profit limited because of lack of patience. MACD is a solution for this problem because it is so delayed and this delay forces you to wait more, both when you are waiting for a trade setup or when you already have a position. That’s why MACD is recommended both by forex and stock traders.

There are a lot of cases that your other indicators and even the price chart show you a signal but MACD tells you wait and it keeps you from going against the trend and losing money. There are also a lot of cases that you want to follow a trend but MACD tells you it is too late and the trend is exhausted and may reverse very soon. In this article, I will do my best to cover all of these cases and help you use MACD in your trades in the best way.

What is MACD Definition?

MACD stands for Moving Average Convergence / Divergence. MACD is an indicator which is used in technical analysis. This indicator is developed by Gerald Appel who was a trader and market technical analyst.

MACD is the difference of a 12 and a 26 exponential moving average. MACD subtracts the 26-period from the 12-period and the result will be displayed in a single line which is the MACD main line. Typical MACD indicators, have one extra line, which is a simple moving average of the main line. This moving average is set to 9 by default. In MetaTrader, the default MACD doesn’t have the main MACD line. Instead, it has bars (histogram). On other platforms, you can see both the MACD main line and MACD histogram.

MACD Formula:

If you are a trader, probably MACD formula will have no use for you. You will need it, if you are a programmer and want to use MACD in designing and developing an EA (expert advisor) or robot.

Download the Colored MACD:

The MACD that comes with MetaTrader by default, has only one color with the histograms. If you like to have the same colored MACD we have on our charts, please download and install it to your platform before we start explaining about MACD and the way we use it in technical analysis and forex trading. This indicator works in MetaTrader. You need to copy and paste it to the /experts/indicators/ folder and then restart your platform and apply the indicator on the price chart: Click Here

How Does MACD Looks Like on The Price Chart?

The below chart shows how colored MACD looks like. It also has the Simple Moving Average (9) but I always set it to 0 because I don’t need it. It doesn’t help. In the indicator you downloaded above, it is set to 0 by default, but you can change it back to 9 if you like.

The MACD bars (histogram) you see below, reflect the difference of the 12 and 26 exponential moving average. On the price chart, you see two exponential moving averages. The green one is the 26 and the red one is the 12. As you see, wherever the distance of these two moving averages is longer, the MACD bars are longer too and wherever these two moving averages cross, the length of the related MACD bar is zero (follow the arrows).

As you see, when there is an upward (Bullish) movement and pressure, MACD goes up and changes its color to blue and when there is a downward (Bearish) pressure and movement, it goes down and changes its color to red.

MACD - Moving Average Convergence / Divergence

MACD bars form highs and lows. When we have an uptrend, they form higher highs and when we have a downtrend, they form lower highs and when the bars go under the zero level, they form lower lows:

How does MACD save you from going against the trend?

As I mentioned, MACD is delayed and so when you see a reversal signal with the candlesticks and Bollinger Bands and you want to take a position against the trend, MACD tells you “No”. Of course, if you know about the Elliott Waves and also the cycles, you will not take any position against the trend even if you don’t have MACD on your chart, but as knowing the cycles and Elliott Waves is very difficult, you can use MACD to stay on the right way.

For example, you see the below reversal. A candle is formed completely out of the Bollinger Band and then there are three Bearish candles that are all reversal signals. Three candles before this, you already had another reversal but you should have ignored it because it was fresh and came just after a big Bullish candle. But, the second sell signal (in the yellow zone), assured you that you can go short. Lets say you wouldn’t have MACD on your chart or you wouldn’t pay any attention to it. You could go short and set your stop loss above the highest high.

and guess what? Your stop loss would be triggered:

So going against MACD is dangerous. But, it is not the only mistake you can make. MACD also indicates if market is overbought or oversold. When it is overbought, it is risky to go long and when it is oversold, it is risky to go short. When market is overbought, Bulls (buyers) can start collecting their profit (they sell) at any time and so the price goes down and when market is oversold, Bears can start buying at any time and so the price may go up. Of course, the candles also tell you if market is overbought or oversold, but MACD is also a big help. Lets see an example.

You are a trend trader. You have an uptrend here. You see some reversal signals but you wait for a continuation signal to go long. A strong Bullish candle forms (the last candle) and at the same time the last MACD bar changes it color and shows an upward pressure. This is what you have been waiting for to go long but you don’t consider that market has been going up for a long time and can reverse at any time. Of course it could go much higher, but we never know.

This position goes up only for one more candle and then goes down and triggers your stop loss:

MACD Buy-Sell Signals:

MACD trading is so common among forex traders. They just wait for a fresh MACD movement for a few bars and then they enter. MACD is really good for trend trading. It is also good for confirming the reversal signals. However, MACD has to be used as a confirmation. The main indicator is the price chart and technical analysis. If you use MACD as a confirmation for support and resistance break, it will be a big help.

Look at the below image. There is a trend line with valid and visible support line. You are waiting for the support breakdown to go short. MACD starts going down for several candles before the break down, but you don’t go short because it can bounce up as soon as it touches the support line. One of the candles closes below the support line and at the same time, you see that MACD is going down, BUT it is fresh and it is not oversold. It is above the zero level too. So you go short at the open of the next candle, set your stop loss above the high price of last candle and your target will be the next support level. It goes down and hits the target very easily.

Now look at the below image which is in fact the same as the above image, but it just shows another support break down which happens a while after the above support breakdown. Obviously, it is a new chance to take another short position, but look at the MACD and its difference with the previous position. In the previous position, MACD had started going down while it was way above the zero level. It means, you would go short while market has been overbought which is a good decision. In this position (below), not only MACD is not above the zero level, but it has already started going up and making higher lows. So market is oversold and your sell signal is not fresh. It is a second hand sell signal

and guess what happens if you would go short and would not consider MACD:

So your position triggers the stop loss before it hits the target.

MACD Divergence:

MACD Divergence is one of the most famous and strongest trading signals that MACD generates. MACD Divergence forms when the price goes up and makes higher highs and at the same time, MACD bars go down and make lower highs. The rule says, the price will finally follow the MACD direction and will break down. However, the problem is, you never know when the price will follow the MACD direction. So, if you rush and take a short position right when you see a MACD Divergence, it may keep on going up for several more candles. You should go short when MACD Divergence is followed by a good sell signal by the candles and/or a support break down. This is safer.

MACD Divergence can be seen at the end of uptrends. What does it mean? It means if you are a trend trader, you should not go long when you see that a MACD Divergence is formed. It can collapse at any time.

MACD Divergence

MACD Convergence:

MACD Convergence is also a famous signal but people trust the MACD Divergence more because when the market goes down and collapses, it goes faster and stronger. Fear is stronger than greed and when market goes down, fear is the dominant emotion.

MACD Convergence forms when price goes down and forms lower highs or lower lows but at the same time MACD bars go up and form higher highs or higher lows. The rule says, the price will finally change the direction and will follow MACD which means it goes up. MACD Convergence can be seen at the end of downtrends. What does it mean? It means if you are a trend trader, you should not go short when you see that a MACD Convergence is formed. It can jump up at any time.

MACD Convergence

Further Reading:

65 Comments:
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Comment by Dave Schneider

2009-05-21 04:54:08

Thanks Vahid!

Excellent article! Now I understand why even though I follow candle breakout signals on my chart, the market is still going against my direction all the time.

Now only if we have the fib lines back in the chart