MACD is one of the most reliable indicators. Although we do not believe in using indicators in our own trading and we always use the price candlestick chart to find the trade setups, we look at MACD direction when we find a signal on the price chart. So we use MACD to confirm the trade setups, and it really works for us. There are so many professional traders (both stock and forex traders) who rely on this indicator. Of course, we should not exaggerate about it. It is not a magic tool to show you the buy/sell signals. But we can say that it is a great indicator compared to the others.
Why MACD works?
That is a million dollar question. Before we answer this question that why MACD works, we 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 trade setup. 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, and when you 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 trader setup, but MACD tells you to 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 that it is too late and the trend is exhausted and may reverse at any time. In this article, we 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 an exponential moving average of the main line. This moving average is set to 9 by default and it is called signal line. 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 histogram is the difference of MACD main line and the 9 exponential moving average:
MACD Histogram: MACD Main Line – Signal Line
As you see, MACD is nothing but the combination of two moving averages. In spite of this, it is a very strong and reliable indicator because it eliminates the market noise.
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. However, the formula helps you understand the indicator better. We already talked about this indicator’s calculation:
Main Line: 12 EMA – 26 EMA
Signal Line: 9 EMA of Main Line
Histogram: Main Line – Signal Line
Download the Colored MACD:
The MACD that comes with MetaTrader by default, has only one color with the histogram. If you like to have the same colored MACD we have on our charts (below screenshots), 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 to download the colored MACD.
How Does MACD Looks Like on The Price Chart?
The below chart shows how colored MACD looks like. It also has the Moving Average (9) but we always set it to zero because we don’t use it. It doesn’t help. In the indicator you downloaded above, it is set to zero 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 main and signal lines. On the price chart, you see the main and signal lines. The red one is the main line and the green line is the signal line. As you see, wherever the distance of these two moving lines is bigger, the MACD bars will become longer too, and wherever these two lines cross, the length of the related MACD bar is zero (follow the black arrows).
As you see, when there is an upward (Bullish) movement and pressure, MACD histograms go up and change the color to blue and when there is a downward (Bearish) pressure and movement, they go down and change the color to red.
MACD bars form highs and lows. When we have an uptrend, they form higher lows 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 we 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 track.
Please look at 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 it 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 had it but 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 riskier to go long and when it is oversold, it is riskier to go short. When market is overbought, Bulls (buyers) can start collecting their profit (they sell) at any time, and so the price may go 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 take a look at 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 the market has been going up for a long time (overbought) and can reverse at any time. Of course it can 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 breakout, 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 breakout to go short. MACD starts going down for several candles before the breakout, 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 the same as the above image, but it just shows another support breakout which happened a while after the above support breakout. 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 the market is oversold and your sell signal is not fresh. It is a second hand sell signal
and guess what happened if you would go short and would not consider MACD:
So your position triggers the stop loss before it hits the target.
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 go 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 the 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 breakout.
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 the MACD Divergence is formed. It can collapse at any time.
MACD Convergence is also a famous signal but people trust the MACD Divergence more because when the market collapses and goes down, it goes faster and stronger. Fear is stronger than greed and when markets go 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 will go 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 the MACD Convergence is formed. It can jump up at any time.