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MACD

Introduction

The MACD is a technical analysis tool and a very popular one. MACD is an acronym for
Moving Average Convergence and Divergence. It is frequently used in Forex Trading
and has evolved into different looking versions; even though all are essentially the
same.

The MACD was first developed by Gerald Appel in late 1970s. Since then it has spread
to become the staple of technical analysis. It has become famous because of its ability
to reliably spot and highlight the momentum of short term trends.

The MACD is a centralized Oscillator indicator, i.e. its calculated value oscillates back
and forth around the central value of 0.

In order to understand how the MACD works, it would be helpful to take a brief look at
moving averages first.

Note that in the price move above, a bearish crossover of the EMAs (faster EMA
moving below the slower EMA) takes place. This indicates that the price is moving down
more rapidly than it was doing so in the past. Also note that as the momentum of the
downward trend rises, the two EMAs move further apart, or diverge, and as the
momentum dies, the EMAs converge.

It is this divergence and convergence that the MACD exploits.

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Construction of the MACD


The MACD comprises of three different features.
1. MACD Line
2. Signal Line (a Moving Average of the MACD line)
3. Histogram (the difference between the MACD Line and the Signal Line)

The Zero Level is the center line that the Histogram emerges from. This level is
important.

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MACD Line
A fast EMA and a slow EMA of the price are calculated to begin with. These will be
moving averages that you can apply to a price chart.
The most frequent ones used are a 12 period EMA and a 26 period EMA. The
difference between these two EMAs is plotted as the MACD Line. The MACD line is
positive when the 12 EMA of the price is above the 26 EMA and the MACD line is
negative (i.e. below 0) when the 26 EMA is above the 12.

The MACD Line shows the degree of separation of the 12 and 26 EMAs in points.

When the 12 EMA and the 26 EMA are touching each other as in the case of a
crossover, the MACD Line will be touching the Zero Line as there is no separation.

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When the 12 EMA drops below the 26 EMA, the MACD will drop under the Zero Line.
The further the separation between the 12 and 26 EMAs, the lower the MACD Line will
be. As the 12 and 26 EMAs separate, the MACD line will drop, as they start to come
together and the separations lessens, the MACD Line will start to rise towards the Zero
Line.

When the 12 rises above the 26 EMA, the MACD Line will rise above the Zero Line. As
the gap between the 12 and 26 widens, the MACD Line will climb. As the 12 and 26
start to come together and the gap lessens, the MACD Line will drop and get closer to
the Zero Line.

In the example above, you will see when the 12 EMA crosses below the 26 EMA, the
MACD Line moves downward. At 10 points of separation, the MACD Line is below the
Zero Line by 10 points. At 15 points of separation, the MACD line drops farther to 15
points below the Zero Line. As the 12 and 26 start to come together, the MACD Line
rises as there are fewer points of separation. On the chart, I marked where there is only
5 points of separation and the MACD Line is 5 points below the Zero Line.

The same happens when the 12 EMA is above the 26 EMA. The MACD line is above
the Zero Line and shows the degree of separation.

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Signal Line
Just as we are able to plot a moving average on the price, we can plot a moving
average on the MACD Line. We plot a 9 period SMA on top of the MACD Line, and this
gives us our signal line. The Signal line is usually a Simple Moving Average, unlike the
MACD Line which is made up of EMAs.

The signal line is important to us because it shows us momentum. It's a clear picture of
whether or not the market has momentum to it.

In a down trend (the MACD line is under the Zero Line), we can tell if that downward
momentum is weakening as the MACD Line crosses above the Signal Line.

In an uptrend (the MACD Line is above the Zero Line), we can see when the upward
momentum is lessoning as the MACD Line drops below the Signal Line.

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Histogram
Just like we can plot the MACD Lone as a difference between 2 moving averages, we
can plot the Histogram in the same manner.

The difference, at all points, between the already plotted MACD line and the Signal Line
is then calculated. This difference is represented as a histogram on the chart. When
the MACD line is above the Signal Line, the histogram is positive (above the Zero Line),
and when the MACD line is below the signal line, the histogram is negative (below the
Zero Line).

Because MACD uses Moving averages in calculation, it is a lagging indicator. However,


it is not as slow as Moving Averages because a crossover can be predicted in advance
or anticipated by taking note of convergence between the MACD line and the Signal
line.

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Uses
The MACD, as stated earlier, is a lagging indicator. However, because it uses derivates
of the price EMAs and not the actual price EMAs, its signals tend to come faster than
those from other lagging indicators.
The MACD can show the trend of the price, the trend’s moment, start or end of new
trends and even anticipate trend reversals following divergence between its signals and
the price movements (we will get into MACD divergences later on in the report).
It is usually used alongside with another indicator. Pairing the MACD with two Moving
averages overlaid on the chart is very common. However, it can also work well with
other indicators such as the RSI.
MACD in itself is considered to be one of the most reliable indicators; some traders
even trade by simply analyzing chart patterns and the MACD along with sparsely used
technical tools such as trend lines and support and resistance levels.

Application
The MACD is a very versatile indicator and is so common that traders have found ways
to incorporate it into almost every trading system.
There are several ways in which the MACD can be analyzed to understand what the
market is currently doing and take the right position. Discussed below are techniques
which you can use if you decide to utilize the MACD in your technical analysis.

1. The Zero line


This is one of the simplest ways in which the MACD can be used.
It has already been briefly mentioned that two Moving averages, a fast and a slow, can
be used to determine the trend of the market.
If the faster moving average is above the slower, the trend is an uptrend.
If the faster moving average is below the slower, the trend is a downtrend.
Also,
If the two price EMAs are diverging (moving apart), the trend momentum is increasing.
If the two price EMAs are converging (moving towards each other), the trend
momentum is decreasing.
The above information is displayed all at once with the MACD Line which is simply the
difference between faster EMA and the slower. Therefore, when the faster EMA is

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above, the MACD line will be above the center 0 line and vice versa. When the two
EMAs cross over and are equal, the MACD line will intersect with the center ‘0’ line.
To state it all concisely, a positive MACD line indicates an uptrend and a buy
opportunity and vice versa for a negative line.
In the image below, note how the highlighted crossovers between the 12 EMA (red) and
the 26 EMA (blue), of the price, coincide with the intersection of the MACD line with the
center ‘0’ line.

The same is true during a down trend.


The advantage of using the Center line technique with the MACD is that it is very easy
to interpret and can be used for getting an idea of the trend with just a glace.

2. The MACD trade signal


There is another way, a more common way, in which the MACD is used with its full
faculties.
The MACD Signal line, sometimes also known as the trigger line, is used to signal the
start of a new trend or a trend reversal.
There are two kinds of MACD Signal Line and MACD Line crossover that you are
looking for with this technique.
A bearish crossover occurs when the MACD signal line moves above the MACD line
(Corresponds with a negative histogram)
A bullish crossover occurs when the MACD signal line moves below the MACD line.

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(Corresponds with a positive histogram)


Note that both, the MACD signal line and the MACD line, are EMAs but NOT of the
price. The signal line is a 9 period EMA of the MACD line, thus, it is slower moving and
smoother than the MACD line itself.

In the chart above, a standard MACD, with parameters of (12,26,9), is applied on a 1hr
EURUSD chart. Along with this, a 12 EMA and 26 EMA of the price are plotted for
reference.

You can see that at the beginning of a sharp down trend, there was a Bearish EMA
crossover which coincided with a Bearish MACD crossover, the histogram became
negative, the MACD line moved below the 0 line. As the down trend continued, the
move gathered momentum and the MACD histogram continued to form new lows
(indicated by red histogram bars).
As the downward move ended, we see a Bullish MACD crossover. The MACD line
moved above the signal line and the histogram became positive. This was a trend
reversal. Note that even though MACD is classified as a lagging indicator, in this case, it
anticipated the trend reversal before classic lagging indicators such as the Moving
Averages seem above.
MACD is often combined with another indicator and used in this manner to confirm
trend.

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The chart above is another example of MACD crossovers, which generally precede
EMA crossovers, on a 1Hour EURUSD chart.

3. Divergence
The divergence is another signal that traders commonly keep a look out for but is
generally employed by experienced traders.
The MACD divergence is a divergence between the signals we get from the MACD and
the price charts. The MACD histogram is most commonly used to spot a divergence.
A divergence occurs when the MACD histograms forms higher highs or lower lows but
the price does not or if the MACD histogram doesn’t form higher highs or lower lows but
the price does. This is a discrepancy between the price movement and the movement’s
momentum.
Divergence can be used to anticipate a trend reversal.

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In the chart above, the price on the left continues to move up, despite the fact that the
MACD histogram fails to make higher highs. This indicates that the price’s momentum is
faltering but it is still clearly moving up.
The anticipated downward move eventually comes. A lot of times price can continue to
make a few higher push upwards and test the momentum before changing direction.
This frequently stops out traders who try to profit from divergence.
A good safeguard against that is to enter a partial position upon spotting a divergence
and only commit to the trade fully when you confirm a trend reversal, which in this case
happens after the divergence with the Bearish crossover of the price EMAs.

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Above is another example of a MACD price divergence. The price consistently made
lower lows while the MACD histogram made higher lows. A dying momentum while the
price continues its trend is the sign of a possible trend reversal.
A good place to enter the market here would be to at the EMA crossover which confirms
that the downtrend has ended. EMAs are lagging indicators and this is why some of the
down trend which could have been capitalized on, has been lost. MACD Divergence
can also be used with another indicator such as the RSI, to confirm the anticipated trend
change more quickly. Of course, this approach will increase the risk of the trades.
In effect, trading a divergence is like calling a bluff between the price and its lack of
momentum. There is potential to be wrong. Most traders will stop the trade out if the
MACD histogram forms a higher high (during a negative divergence) or a lower low
(during a positive divergence), indicating that trader was wrong and the price still has
the momentum and strength to continue its trend.

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Prophet Oracle Trading System


The Prophet Oracle is a trading system based on what the MACD tells us to do. There
are times when the MACD seems to be able to tell the future, like a Prophet.
We will be using the MACD to trade with the trend and also against the trend.
This is what the system looks like, it's quite simple, but it's very profitable:

The indicators used:


5 period Simple Moving Average (5 SMA - blue line on the chart)
55 period Simple Moving Average (55 SMA - red line on the chart)
MACD with the standard settings (12, 26, 9)

*Note
The MACD we are using is called the MACD-2Line, this one is a better version than
what is provided by the MT4 platform.

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The Trend
We want to identify the trend in order to trade with it or against it.
To determine the trend, we will be looking to the moving averages on the chart.

When the 5 SMA (blue MA) is above the 55 SMA (red MA), the trend is up.
When the 5 SMA is below the 55 SMA, the trend is down.

The trend is important to note, but using the MACD, we are going to get a clear signal
when the momentum of a trend is gone and risky to trade.

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In an uptrend, we want to avoid any trades when the MACD Histogram is red. This is a
clear signal that the upward trend has no momentum.

In a downtrend, we stay away from short trades when the MACD Histogram is green.
The downward momentum is gone, so trading with the trend becomes dangerous.

When the Histogram changes color, this is NOT a signal to trade against the trend, it
simply shows us that the market is in a resting period and will potentially flounder before
resuming the trend.

In the example above, you can see the red Histogram in an uptrend, the market moves
sideways and slightly against the trend. It's not enough movement to take a counter
trend trade, but a trend following trade would have been stopped out.

The same goes for the green Histogram in a down trend. It's a conflict between the
trend and the momentum of the market.

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Trend Trades
The MACD Histogram Trade:

BUY TRADE

In an uptrend, we will take a long trade when the MACD Histogram turns from red to
green. When the trend is up, we will wait for the Histogram to turn red, this becomes the
setup. The trade signal happens when the Histogram changes to green at the close of a
candle.

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SELL TRADE

In a downtrend, we will take a short trade when the MACD Histogram turns from green
to red. When the trend is down, we will wait for the Histogram to turn green, this
becomes the setup. The trade signal happens when the Histogram changes to red at
the close of a candle.

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Stops, Targets and Exits


Trend following trades have the potential to go a long way, so for these trades I like to
get more than I risk on the trade.

First though, we want to place a stop loss to protect ourselves if the trade doesn't work
out (yes, this does happen from time to time).

Stop Loss:
In a long trade, the stop loss will be placed just below the move recent swing low that
the market has made. In a short trade, the stop will be placed just above the most
recent swing high.

Target:
I will be placing a profit target 2 times that of the stop loss. This means that if my stop
loss is placed 20 pips away from my entry, I will be placing a 40 pip profit target.

The Histogram trades are placed in the direction of the trend, so they do have the
potential to go a long way. I want to be sure I get as much as I can.

Exits:
For each trade I take, I want to be sure that I get out when the momentum is no longer
in my favor. For this, I will exit the trade when the Histogram changes color.
In a buy trade, I will exit the trade when the Histogram turns red.
In a sell trade, I will exit the trade when the Histogram turns green.

Using the Histogram Exit can also be used if you want to let your trade run. You can
enter the trade and place no profit target, instead just keep the trade open until the
Histogram changes to the opposite color. There are pros and cons for this. Sometimes
your 2:1 target would have been touched, but the price pulls back getting you out of the
trade with less profit. This strategy can also be responsible to getting you much more
than 2:1. You will have to decide what you like best.

For me, I prefer to place a 2:1 target and exit early if the Histogram changes color.

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A buy trade and all its parts:

A sell trade will all its parts:

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Counter-Trend Trades
The Divergence Trade:

BUY TRADE

We will be looking for the trend to be down, or the 5 SMA under the 55 SMA. We will
trade against the trend, or take a buy trade, when we see divergence on the MACD
Histogram.

For a buy trade signal, we first want the market to be in a downtrend.


Next, we want to see the price making a low followed by a lower low.
What we want to see on the MACD is the corresponding lows to be getting higher.
We want to see a red low followed by a higher red low.

This is Regular Bullish Divergence.

The entry signal comes when the MACD Histogram turns green.

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SELL TRADE

We will be looking for the trend to be up, or the 5 SMA above the 55 SMA. We will trade
against the trend, or take a sell trade, when we see divergence on the MACD
Histogram.

For a sell trade signal, we first want the market to be in an uptrend.


Next, we want to see the price making a high followed by a higher high.
What we want to see on the MACD is the corresponding highs to be getting lower.
We want to see a green high followed by a lower green high.

This is Regular Bearish Divergence.

The entry signal comes when the Histogram turns red.

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Stops, Targets and Exits


Trades against the trend have potential, but often they don't go a long way. When the
trend is strong, even divergence doesn't always make the market move. With a
divergence trade, we want to keep our targets to something that we know will get hit on
a regular basis.

First, we want to place a stop loss to protect ourselves if the trade doesn't work.

Stop Loss:
In a long trade, the stop loss will be placed just below the move recent swing low that
the market has made. In a short trade, the stop will be placed just above the most
recent swing high.

Target:
The target in a divergence trade is going to be the 55 SMA.
The 55 SMA is a really good level of dynamic support and resistance and makes for an
excellent target.

Exits:
For each trade I take, I want to be sure that I get out when the momentum is no longer
in my favor. For this, I will exit the trade when the Histogram changes color.
In a buy trade, I will exit the trade when the Histogram turns red.
In a sell trade, I will exit the trade when the Histogram turns green.

Using the Histogram Exit can also be used if you want to let your trade run. You can
enter the trade and place no profit target, instead just keep the trade open until the
Histogram changes to the opposite color. The 55 SMA is a great target and the market
will often turn around at this level, but like all support and resistance, once price breaks
past it, there is the potential for the market to keep on going. Holding onto a trade until
the Histogram changes color is a good way to get the most from a trade that does move
through the 55 SMA.

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A buy trade and all its parts:

A sell trade and all its parts:

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Summary

The MACD is a very versatile, reliable and useful lagging indicator which is used by
almost every Forex trader.
The MACD itself consists of three parameters and is a derivative of two price moving
averages;
1. MACD line: Difference between 12 EMA of the price and the 26 EMA of the price.
2. Signal line: 9 period SMA of the MACD line
3. Histogram: Difference between the MACD line and the Signal line plotted as a
histogram.
The indicator has a mean center line at 0 around which the histogram oscillates, we
refer to this as the Zero Line because this is where there is zero separation between the
2 moving averages it derives its calculations from.
When the MACD line is above 0, the 12 EMA is higher than the 26 and vice versa.
Therefore, the MACD line and its position relative to the center can be used to get an
idea of the trend quickly.
Generally, a trade signal is taken from the MACD when the MACD line and the Signal
line intersect. When the MACD line is on top, it is a bearish signal or trend and vice
versa. The bearish or bullish crossovers of the MACD and the Signal line can often
predict trend reversals very accurately.
Experienced traders also keep an eye out for Divergences; which is a discrepancy
between the MACD signals and the price movement. The MACD histogram indicates
the strength of the move or the momentum. When the histogram fails to make higher
highs or lower lows, the strength of the trend is fading and it is likely to end. Sometimes
the price can continue its trend while this happens, it's just doing it with very little
momentum. This is a divergence and it foreshadows a trend reversal. It is advisable to
use a secondary indicator when trading divergences and committing to it when the trend
change is confirmed.
The MACD is one of the most popular indicators and there is a reason it has become so
famous. Of course, no indicator can predict the market 100% of the time but use of the
MACD should give you a better understanding of the market moves and support your
technical analysis.

Sincerely,

Russ Horn

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