Tuesday, October 7, 2008

MACD Forex Indicator

Not So Average The Moving Average Convergence Divergence (MACD) forex Indicator

Stocks and indices trend higher and trend lower on a short-, intermediate- and long-term scale. However, trends are composed of a period of backing and filling. This step-like action produces “mini” trends within the bigger picture. Savvy traders can exploit these smaller-scale trends for profit, and one of the best tools for this is an indicator called the Moving Average Convergence Divergence (MACD).

The MACD was developed by Gerald Appel, and is one of the simplest, most reliable indicators available for all types of forex traders. The forex indicator uses moving averages, which are essentially lagging forex indicators, to include some trend-following characteristics. These lagging indicators are converted into a momentum oscillator by subtracting the longer moving average from the shorter moving average. The result is a line that oscillates above and below zero, without any upper or lower limits. Like many forex indicators we use, it is a centered oscillator, meaning that it will always gravitate toward the center line when the forex trend is reversing.
To completely understand the MACD, one needs to recognize that the relationship between the fast line and the slow line is critical. On a standard forex MACD, the fast line results from the difference between the 26-day exponential moving average (EMA) of the closing prices subtracted from the 12-day EMA of the closing prices, giving the calculation for the fast line. Further, the slow signal is a moving average of the fast line. You can determine the slow forex signal by calculating the nine-day EMA of the fast line. The calculation for the fast line is 12 and 26 days, or if you’re forex trading on a longer-term scale, weeks. But, you will find that all forex software programs available will use days rather than weeks. The defaults are easily changed if the technician wishes to changes the time period. Appel and others have tinkered with these original settings to come up with a MACD that is better suited for faster or slower securities. Using shorter moving averages will produce a quicker, more responsive indicator, while using longer moving averages will produce a slower indicator, less prone to whipsaws. For our purposes in this article, the traditional 12/26 MACD will be used for explanations.
If you’d like to study the advanced uses, there are many books on the subject.
The slow period is always a nine-day or one-week period. The two EMAs will tend to cross over each other from time to time, signaling buy and sell action. It is clearly understood that crossovers will signal the beginning and the end of both up trends and down trends. Much has been written about the centerline of the MACD being the key to the strength, as we will see when we go to some examples. When the crossover occurs, whether indicating a buy signal or a sell signal, knowing where it happens in relationship to the center line is going to determine just how powerful the movement is going to be.

A positive MACD indicates that the 12-day EMA is trading above the 26-day EMA. A negative MACD indicates that the 12-day EMA is trading below the 26-day EMA. If MACD is positive and rising, then the gap between the 12-day EMA and the 26-day EMA is broadening. The interpretation of that is the rate of change of the faster moving average is higher than the rate of change for the slower moving average. Positive momentum is escalating and this would be considered bullish. If MACD is negative and declining further, then the negative opening between the faster moving average and the slower is getting bigger. Downward momentum is “snowballing” and this would be considered bearish for the stock or index. MACD centerline crossovers occur when the faster moving average crosses the slower moving average.
Now that we’ve covered the mathematical side of the MACD, let’s take a look at the art of interpreting the indicator. There are three common methods for making investment decisions with the MACD:
I. Crossovers – As we touched on above, when the MACD falls below the signal line, it is a signal to sell. When the MACD rises above the signal line, it is a signal to buy.
II. Divergences - When a security or index diverges from the MACD indicator, it often signals the end of the current trend.
III. Overbought/Oversold - When the MACD rises dramatically (i.e. the shorter moving average gets extended away from longer-term moving average), it is a signal the security is overbought and will soon return to normal levels.

Let’s take a look at a few examples. These examples are primarily showing the first method of interpretation (the crossovers). However, the other two are easily applied.
Our first example is a daily chart for Goldman Sachs (GS). During this time frame, GS had been in a down trend. It transitioned and then moved into an up trend. I’ve drawn red and green vertical lines on the chart to show you where you would have bought (green lines) and sold (red lines) the stock simply on the MACD crossovers. In this instance, the MACD was hitting the ball out of the park. During the transition period, you made significant gains to the upside without taking on the risk of the significant corrections. In fact, I’d venture to say you outperformed the stock if you had bought and held it and you outperformed the buy-and-hold strategy with less risk. Keep in mind that the most powerful signals, and thus the most valid signals, are given when the stock is the most extended away from the center line. Thus, crossovers in any place are valid buy-and-sell signals, but the “best” signals are the ones given further from the zero line.
Let me clarify that the forex MACD is represented in two ways on this chart. First, it’s showing the general line crossovers via the red and blue lines. Second, there is a pink MACD Histogram showing you the buy and sell signals. Both give the exact same signals. However, the histogram gives buy and sell signals as it crosses the mid line. Again, they both give the exact same signals, but read a tad differently.

Next, let’s take a look at the longer-term picture of the market as we transitioned from a bear to a bull market in late 2002. The chart below is a weekly chart for the S&P 500. For longer-term traders who want to do less trading and simply position trade, using weekly charts is an ideal scenario. In the example below, the market only gave six trade signals over a period of three years. The first three signals were pretty much whipsaws in both directions. However, the last three gave significant returns and, again, offered the investor much less risk. The MACD got you in the market while it was trending higher and kept you out during corrective phases.
The MACD is an indicator that will help all chartists in their trend analysis and assist you with your ability to get in and out of situations in which it may be tempting to remain in the hopes that fortunes may turn around. I have found the indicator to be particularly effective when you come across stocks that are transitioning from down to up trends.

Finally, as I always preach to you, no indicator is an “end-all” by itself. The MACD is going to be much more effective for you if you attach a solid “internals” indicator like Money Flow or (my favorite) On-balance Volume. Remember, you have a number of tools in your toolbox and you shouldn’t be afraid to use them in combinations.

1 comment:

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