We, Homo sapiens, prefer to live in our comfort zone. We love to change but hate being changed. The same applies to trading; we sometimes only stick to the basic concepts and try to achieve big. It is not possible to be great without burning the midnight oil. So, I thought to share some advanced knowledge on forex tools.
Keeping our thoughts aligned, I’d like to write this blog on a straightforward and easy-to-use tool called Moving Average Convergence Divergence. Yes, that is one of our most often used indicators. Right?
A moving average represents the average value consensus over a selected time period or a composite photo of mass consensus. It identifies trends by filtering out daily price fluctuations.
Excessive variation makes it difficult for traders to determine the overall trend of an asset. The price movement is smoothed out by using a moving average. Once the daily fluctuations are eliminated, we can identify the actual trend and increase our chances of winning a trade. The average may be anything, and the time frame is entirely up to the traders. You are free to select any.
There are several types of moving averages, each with a different calculation but the same interpretation. The sole difference between the calculations is the weighting of the price data, which shifts from equal weighting of each price point to increased weighting of recent data.
Simple, linear, and exponential moving averages are the most common.
You may create a useful oscillator by comparing the difference between two moving averages. As a result, employing two moving averages in the double crossover method gains significance and becomes an even more practical technique. Gerald Appel, a New York-based analyst and money manager, deserves full credit for creating this trading indicator in the late 1970s.
It is one of the most basic weapons traders use to extract profit from other traders. It aids in identifying changes in the strength, direction, momentum, and length of a currency’s price trend.
It’s just because it can be employed in both approaches, namely trend following, and momentum trading. Isn’t it interesting?
You are most definitely aware that the MACD line, the quicker line, is the difference between two exponentially smoothed moving averages of closing prices (usually the last 12 and 26 days or weeks).
The slower (or signal) line is often a 9-period exponentially smoothed average of the MACD line.
You may recall that the creator initially recommended one set of numbers for buying signals and another set for selling signals. But what do we do with it? I nearly heard your voice. You must have mentioned 12, 26, and 9. In all instances, these numbers are set as default values.
MACD is calculated by subtracting the long-term EMA (26 periods) from the short-term EMA (12 periods). An exponential moving average (EMA) is a sort of moving average (MA) that places the most recent data points more weight and significance.
The exponentially weighted moving average is another name for the exponential moving average. An exponentially weighted moving average (EWMA) reacts to recent price changes more significantly than a simple moving average (SMA), which gives equal weight to all observations in the period.
MACD=12-Period EMA − 26-Period EMA
It would help if you now had a good understanding of MACD. The original MACD indicator consists of a solid line (sometimes referred to as the MACD Line) and a dashed line (also known as the Signal Line).
The former line, the MACD line, is made up of two exponential moving averages (the abbreviated form is EMA).
It responds to price changes relatively quickly, as made to the signal line, simply the MACD line smoothed with another EMA.
Compared to the MACD line, it usually reacts slowly to price changes.
Let me walk you through the method for creating a MACD indicator step by step.
If you have this in your subconscious mind, you can definitely bypass it.
Step 1) Determine the 12-day EMA of closing prices.
Step 2) Determine a 26-day moving average of closing prices.
Step 3) Subtract the 26-day EMA from the 12-day EMA and depict the difference as a solid line. This is referred to as the rapid MACD line.
Step 4) Determine the fast line’s 9-day EMA and plot the result as a dashed line. This is referred to as the sluggish Signal line.
While it was being constructed, the values 12, 26, and 9 were set as default (though there are some reasons, of course).
It is important to remember that MACD is developed from moving averages.
As a result, it is a lagging indicator by default.
As a further note, it is less useful for securities oscillating in a narrow range, is range bound, or exhibiting erratic movements.
Mac-Dee is nothing more than a game of hide-and-seek between two moving averages.
Yes, you’re right. The convergence and divergence of these two moving averages were what I was referring to. The Oxford dictionary defines convergence as “the process or state of converging.”
In technical analysis, convergence occurs when the moving averages move towards each other, and divergence occurs when the moving averages move away from each other.
It occurs when the moving averages move away from each other.
RSI divergences usually arise between the trend of the MACD lines and the price lines.ATR Indicator - Average True Range — 2023
Before digging deeper into “divergence,” understand the significance of “crossovers.”
The MACD values swing around a zero line (also known as the centre line). It resembles an oscillator. When the MACD value is positive, it indicates that the 12 days EMA has crossed the 26 days EMA from below.
Following the crossover, the deviation of the shorter EMA from the larger counterpart is proportional to positive values.
It signifies an increase in the upward momentum.
When the MACD indicator is negative, it indicates that the 12-day EMA has crossed the 26-day EMA from above.
Following the crossover, the diversion of the shorter EMA from the larger counterpart is directly proportional to negative values.
It signifies an increase in downside momentum.
When the fast MACD line crosses above or below the slow Signal line, buy and sell signals are triggered.
The most common sort of crossovers is signal line crossovers.
Bullish crossovers occur when the MACD turns and crosses above the Signal line.
Bearish Crossovers occur when the MACD indicator falls and crosses below the Signal line.
Overbought and oversold conditions can also be identified.
The condition is called overbought when the lines are too much above the zero line.
On the other hand, an oversold condition occurs when the lines are too much below the zero line.
The crossover above and below the zero line can be used to create buy and sell signals.
Allow me to connect it to your conscious mind.
The crossover technique stated above signals that the shorter EMA, 12 days, has crossed the longer one, 26 days.
The direction of the moving average crossings indicates the direction.
Note: As a chartist, I can tell you that “divergence” is a crucial term in technical analysis.
It appears between the price line and the trend of the MACD lines.
Divergences are classified into two types.
A positive or “bullish” divergence and a negative or “bearish” divergence.
Positive divergence occurs when the MACD lines are considerably below the zero/center line and begin to move up ahead of the price line. It is frequently a signal of a market bottom. To identify significant trend changes, draw simple trendlines on the MACD lines.
A negative divergence occurs when the MACD lines are significantly above the zero/center line and move to weaken as prices continue to rise. It is frequently an indicator of a market peak.
The crossover between the MACD and Signal lines indicates when the market tide is changing. If you trade in the direction of a crossover, you are going with the market’s flow.
Different traders have various perspectives. The trader chooses the trading time frame. As a result, many traders attempt to personalise MACD by using various parameters rather than the default ones (12, 26 & 9).
Another standard option is 5-34-7, which has higher sensitivity than its larger counterpart. The larger the parameters, the fewer the crossings, yet the oscillating character of MACD around zero remains. Furthermore, traders tend to associate MACD with market cycles.
The problem is that cycles are not always present in the markets. When using cycles, the first EMA should be one-quarter the length of the dominant cycle, and the second EMA should be half the length of the cycle.
As you are aware, the third EMA is used for smoothing and does not have to be related to a cycle. Remember that if you play with this instrument long enough, you can get it to produce whatever signal you want with the same data.
The relative strength indicator (RSI) attempts to determine if a market is overbought or oversold concerning current price levels. The RSI is an oscillator that calculates average price gains and losses over a given period.
The time period is set to 14 by default, with values ranging from 0 to 100. A reading above 70 indicates an overbought condition, while a reading below 30 indicates an oversold condition, potentially indicating the formation of a top or vice versa (a bottom is forming).
The MACD measures the relationship between two exponential moving averages (EMAs), whereas the RSI measures price change to recent price highs and lows. These two indicators are frequently employed in tandem to offer analysts a complete technical picture of a market.
These indicators both measure market momentum, but they can occasionally offer contrary indications because they measure different factors. The RSI, for example, may show a reading over 70 (overbought) for a sustained period, indicating that the market is overextended to the buy-side to recent prices. Yet, the MACD indicates that the market is still increasing in buying momentum.
By showing divergence from price, each indicator may signal an upcoming trend change (price continues higher while the indicator turns lower, or vice versa).
One of the primary problems with a MACD divergence is that it might signal a possible reversal, but then no actual reversal produces—creating a false positive. Another problem is that divergence does not forecast all reversals. In other words, it predicts too many false reversals and not enough true price reversals.
This implies that trend-following indicators, such as the DMI system (Directional Movement Indicator) and its major component, the ADX, should be used to seek confirmation (Average Directional Index). The ADX is designed to indicate whether a trend is in place or not, with a reading above 25 indicating a trend.
When the price of an asset moves sideways, such as in a range or triangle pattern following a trend, “false positive” divergence occurs frequently. Even without an actual reversal, a slowdown in price momentum (sideways or slow trending movement) will cause the MACD to pull away from its prior extremes and gravitate toward the zero lines.
When the MACD falls below the signal line, it is a bearish signal indicating it is time to sell, as illustrated in the chart below. When the MACD crosses above the signal line, the indicator offers a bullish signal, indicating that the asset’s price is likely to rise.
To reduce the possibility of getting “faked out” and entering a position too early, some traders wait for a confirmed cross above the signal line before entering a position.
Crossovers are more reliable when they follow the current trend. If the MACD crosses above its signal line after a brief downtrend inside a longer-term uptrend, it indicates bullish confirmation and the likelihood of the uptrend continuing.
If the MACD crosses below its signal line after a brief upward move inside a longer-term downtrend, traders will interpret this as bearish confirmation.
A divergence occurs when the MACD generates highs or lows that differ from the corresponding highs and lows in price. A bullish divergence occurs when the MACD creates two rising lows that coincide with two falling lows in the price. When the long-term trend remains positive, this is a reliable bullish signal.
Although this technique is less reliable, some traders may seek bullish divergences even when the long-term trend is negative since they can signal a change in the trend.
A bearish divergence occurs when the MACD establishes a sequence of two falling highs that correlate with two rising highs in the price. A bearish divergence that develops during a long-term bearish trend confirms that the trend is likely to continue.
Some traders may look for bearish divergences during long-term bullish trends since they might signal trend weakness. However, it is not as reliable as a bearish divergence during a bearish trend.
When the MACD rapidly rises or falls (the shorter-term moving average pulls away from the longer-term moving average), it indicates that the security has been overbought or oversold and will soon return to normal levels. Traders frequently use this analysis with the relative strength index (RSI) or other technical indicators to confirm overbought or oversold positions.
Investors frequently use the MACD’s histogram in the same manner they use the MACD itself. Positive and negative crossovers, divergences, and quick rises and falls can all be seen on the histogram. Because there are temporal disparities between signals on the MACD and its histogram, some experience is required before selecting which is better in any given situation.
Traders use MACD to identify changes in the direction or strength of a currency’s price trend. MACD may appear complicated at first glance since it relies on additional statistical concepts such as the exponential moving average (EMA).
However, MACD fundamentally assists traders in detecting when recent momentum in a currency’s price may signal a change in its underlying trend. This can assist traders in determining when to enter, add to, or exit a position.
MACD is a lagging indicator. After all, all of the data used in MACD is based on the currency’s historical price action. Because it is based on historical data, it must necessarily “lag” the price. However, some traders use MACD histograms to predict when a trend may change. These traders may view this aspect of the MACD as a leading indicator of future trend changes.
A MACD positive divergence occurs when the MACD does not hit a new low despite the currency’s price reaching a new low. This is interpreted as a positive trading signal, thus the term “positive/bullish divergence.” If the currency price makes a new high, but the MACD does not, this is a bearish indicator referred to as a negative or bearish divergence.
The MACD is a primary indicator that appeals to intuitive reasoning and connects well with most traders. It may be a robust tool if used correctly, particularly for measuring the intensity and velocity of trends and, as a result, forecasting their continuation and a probable reversal.
The possibility of false positives is one of the MACD’s most severe shortcomings. A reversal is predicted but never occurs. The opposite can also occur when a reversal occurs without being signalled. A MACD signal line filter might be used to try to overcome any of these erroneous signals.
The histogram, with the bars representing the difference between the MACD and signal lines, is arguably the most valuable part of MACD. When the market price moves vigorously in one direction, the histogram expands in height; when the histogram contracts, the market moves slower.