Moving Average Convergencedivergence

Is there a better indicator than the moving average convergence/divergence (MACD)? Some traders will assuredly say yes, of course there is. But for me the MACD is the most potent technical tool in my arsenal. In fact, I use the MACD and my Bollinger band "bands" to trade most of my setups in FX. The MACD is one of the simplest indicators around and is extremely versatile as it can be used both to gauge range as well as to trade trend.

Invented by Gerald Appel in 1978, the MACD is undoubtedly one of the top five most popular technical indicators in existence. Appel's brilliant insight was that as technicians we can learn more about price behavior from the interaction between moving averages than from the moving averages themselves. The MACD essentially plots the difference between the currency pair's 12-period and 26-period exponential moving averages. The idea is that if prices are rising, the 12-period exponential moving average (the faster moving average) will increase at a faster rate than the 26-period exponential moving average. The MACD therefore will slope upward. The reverse dynamic will occur if prices are falling. The MACD is an unbounded indicator, but it does oscillate around zero with readings becoming increasingly positive as prices rise and increasingly negative as they fall. One very simple method of trading the MACD is to buy when the MACD value turns positive and sell when it turns negative. Because the MACD records the difference between two moving averages rather than the moving averages themselves, it is far less prone to whipsaws as it filters out the periodic noise (see Figure 6.6).

The MACD is also plotted with its trigger line, which is simply the 9-period exponential moving average of the MACD itself. Much like the moving average crossover, the trigger line signal is traded when the MACD line crosses it from the upside or the downside. Because MACD calculations are naturally slower than the price action, these signals are always generated later than the price action itself. However, although these signals may be late they tend to be more accurate than mere moving average crossovers (see Figure 6.7).

In 1986 Thomas Aspray improved on Appel's original idea by inventing the MACD histogram, for me one of the most useful technical tools in existence. The histogram is simply the visual representation of the difference between the MACD line and its trigger line, but its real value rests on the fact that it is a very effective momentum indicator. The MACD histogram oscillates around the zero line, which is the point at which the MACD and the trigger line cross each other. When prices rise, the MACD will tend to pull away from its trigger line, as the most recent values will cause the MACD to increase at a faster rate than its 9-period EMA.

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Note MACD lags price least in the cast of u short on 5/13 sends a {»ood sell signal In NZD/USD.

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I'IGI RR 6.6 MACD Zero Line Crossover in NZD/USD

Source: FXtrek IntelliChart™. Copyright 2001-2005, Inc.

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•Series of successful MACD crossovers in GBP/USD.

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At its core, the MACD histogram measures the velocity of price movement, which can offer a technically oriented trader a very strong clue to future price action. The key technical concept, in fact the essence of all technical analysis, is that changes in momentum precede changes in price. The concept is actually eminently reasonable if we just think for a moment of what happens during a strong directional move.

Let's imagine that prices are in an uptrend. Buyers have bid the currency pair up, making higher highs. Typically price action will have the following pattern: First prices will break out as early buyers pile into the currency in anticipation of a rise. Then more traders seeing the rise in the currency will join the price action in hopes of extending the trend. Additionally, short sellers who are now deep in loss territory will begin to cover as they realize that they are on the wrong side of the market. This reaction will only fuel prices higher and then Johnny-come-lately buyers will jump on the trend bandwagon, believing that prices will continue their linear progression. At this point most of the players who wanted to buy have already established their positions and the rate of new highs slows. The early buyers who have now amassed substantial profits begin to liquidate their positions as they see prices level off. All of this jockeying translates into one simple fact: Velocity has slowed markedly. If at the beginning of the trend it took only five minutes to move prices higher by 50 points, now it may take several hours to move them only 2 or 3 points higher, or worse yet they may actually begin to decline as early winners take profits while there are no additional buyers to absorb their sells.

The MACD histogram is a very sensitive measure of price velocity and as such is a very useful tool in one of my favorite setups—the MACD turn. The MACD turn essentially trades the MACD histogram rather than the price action itself. A buy signal is generated once the MACD histogram makes a peak. In the case of a long signal the MACD histogram would need to record a higher low on one of its bars. The trader would then assume a long position (see Figure 6.8 for a sell signal). Note that very frequently the price will continue to decline even as the MACD histogram posts higher lows. Most traders will panic at this point and will stop themselves out, typically just at absolute price lows. This is almost always a critical mistake. One of the key tenets of trading with indicators is that the trader should stay with the logic of his setup. If the entry was based on an indicator signal, then the stop-exit should be based on the indicator as well. In the MACD turn example I would stop myself out of the trade only if the MACD value made a new swing low. In the MACD turn trade the trick is to trade the indicator, not the price.

Many novice technical traders will enter on an indicator signal but will exit on some predetermined price. This in fact is the trading equiva-

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MACD histogram makes higher tows triggering a buy signal.

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FIGURE 6.8 Trading the MACD Histogram in AUD/CAD Source: FXtrek IntelliChart™. Copyright 2001-2005, Inc.

lent of comparing apples and oranges. There is little logic in such a setup and it will frequently fail as result. Little wonder, then, that many traders who experiment with indicators quickly give up in frustration and proclaim that technical analysis "does not work." That certainly is true; any set of tools utilized incorrectly will fail at their intended task. However, the most difficult notion to understand about a technical analysis tool like MACD is that even when they are used properly they can fail as well.

The basis of technical analysis is that momentum precedes price. That means failure in momentum will occur before failure in price. In a declining market, momentum will usually taper off before price will stop decreasing. Generally, this is a very high-probability bet. On some occasions, however, momentum will send a fake signal. Note in Figure 6.9 how the MACD initially turns upward suggesting that momentum is increasing but then quickly reverts back. At that point it is critical for the trader to stop himself out because his key criterion—positive momentum in the form of an ever-increasing MACD histogram slope—has been negated.

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MACD histogram rises negating the short setup at the end of this bar.

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MACD histogram rises negating the short setup at the end of this bar.

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10 12 2005

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10 12 2005

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I IGI Ri: 6.9 Stopping Out of a Short as MACD Turns Positive Source: FXtrek InteiliChart™. Copyright 2001-2005, Inc.

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