Define Moving Average Convergence-Divergence(MACD)

Moving Average Convergence-Divergence(MACD)

What is MACD?

Moving Average Convergence-Divergence (MACD) is used either as a trend-following or momentum indicator. It consists of two lines - the MACD line and the Signal line. The MACD line is made up of two exponential moving averages (EMA). It is obtained by subtracting a 26-day EMA of a currency price from a 12-day EMA of the price. This fast MACD line responds to changes in prices quite quickly.

When the MACD is above zero, it is a bullish signal for the currency as it means that current expectations (i.e., the 12-day EMA) are more bullish than previous expectations (i.e., the 26-day EMA). When the MACD goes below zero, it is a bearish signal for the currency as it shows that current expectations (i.e, the 12-day EMA) are more bearish than previously (i.e, the 26-day EMA). The signal line is a 9-day EMA of MACD itself, and it responds to changes in prices more slowly.

MACD generates a bullish signal when the MACD line is above the signal line, and a bearish signal when the MACD line is below the signal line.

MACD Histogram

I find MACD Histogram to a more useful tool than MACD itself because not only does it show you the trend direction, it also illustrates the strength of the price movement. It displays a very good visual representation of the difference between MACD and its 9-day EMA. By looking at the Histogram, you can tell 2 things:

1.  Trend direction

If the Histogram is above zero (i.e, the MACD line is above the signal line), it means the trend is bullish. If the Histogram is below zero (i.e, the MACD line is below the signal line), it means that the trend is bearish.

2.  Momentum of price movement

The higher the slope of the Histogram turns up (expands larger) above zero, the stronger the price momentum, and hence, the more bullish the signal is. The more the slope of the Histogram turns down (expands larger) below zero, the stronger the price momentum, and hence, the more bearish the signal is. The MACD Histogram does not generate any buy or sell signal when the Histogram is at zero.

Figure 1 below shows a daily chart of EUR/USD, with the MACD Histogram below the price chart. As you can see, when the price falls, the Histogram slopes downward more and more into the negative territory, signaling trend bearishness and increasing bearish momentum. When the price rallies, the Histogram slopes upward more and more into the positive territory, signaling trend bullishness and increasing bullish momentum.

Figure 1

In technical analysis, a key principle is that momentum precedes price action. Thus, the MACD Histogram is particularly useful in telling us when the momentum is gaining strength and when it is waning. When the momentum is waning, it signals that the trend may be about to reverse.

How to Use MACD Histogram in Forex Charts

The most useful application of the MACD Histogram is its divergence signals. A bearish divergence occurs when the currency price rallies to a new swing high or back to approximately the same level, but MACD Histogram traces a lower top. This means that bulls are running out of steam to keep bidding higher. Weakness is thus identified at market tops.

A bullish divergence occurs when the currency price falls to a new swing low, but MACD Histogram traces a more shallow low. This means that the bears are weaker than they seem. Strength is thus identified at market bottoms.

Real Chart Example of Divergence

Figure 2 below shows a bullish divergence on the MACD Histogram (with the MACD line and Signal line removed) on a daily chart of EUR/USD. As you can see, while the price reaches a new swing low, the MACD Histogram traces a higher bottom than its previous low. This bullish divergence signals an excellent buying opportunity because it shows that the Euro bulls are ready to take control from the exhausted bears. You may wish to enter long when the price exceeds the high of the last red candle, or when the Histogram emerges into the positive territory.  

Figure 2

Trading Tips for MACD Histogram