Before we discuss about MACD, we need to understand about Moving Average. A Moving Average is simply a way to smooth out price action over time. By “moving average”, you are taking the average closing price of a currency for the last “x” number of periods.
The above chart shows the moving average over 20 periods, MA(20). Like every indicator, it is used to help us forecast future prices. By looking at the slope of the moving average you can make general predictions as to where the price will go.
Note that moving averages smooth out price action. There are different types of moving averages, and each of them have their own level of “smoothness”. Generally, the smoother the moving average, the slower it is to react to the price movement. The choppier the moving average, the quicker it is to react to the price movement.
A simple moving average is calculated by adding up the last “x” period’s closing prices and then dividing that number by “x”. However, simple moving averages are very susceptible to spikes (a sudden jump in price action and back to normal). To rectify the spike problem, there is another moving average called Exponential Moving Average (EMA). EMA gives more weight to the most recent periods, and will filter out spike problems.
What is MACD?
Developed by Gerald Appel, Moving Average Convergence/Divergence (MACD) is one of the simplest and most reliable indicators available. MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics. This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish.
The most popular formula for the "standard" MACD is the difference between a security's 26-day and 12-day exponential moving averages. 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.
Of the two moving averages that make up MACD, the 12-day EMA (Exponential Moving average) is the faster and the 26-day EMA is the slower. Closing prices are used to form the moving averages. Usually, a 9-day EMA of MACD is plotted along side to act as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA.
Look at the chart below.
The chart above shows the 12-day EMA (dotted blue line) or EMA(12) with the 26-day EMA (dotted gray line) or EMA(26) overlaid the price plot. MACD appears in the box below as the blue line and its 9-day EMA is the red line. The histogram represents the difference between MACD and its 9-day EMA. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.
MACD measures the difference between two moving averages. A positive MACD indicates that the EMA(12) is trading above EMA(26). A negative MACD indicates that the EMA(12) is trading below the EMA(26). If MACD is positive and rising, then the gap between the EMA(12) and the EMA(26) is widening. This indicates that the rate-of-change of the faster moving average is higher than the rate-of-change for the slower moving average. Positive momentum is increasing and this would be considered bullish. If MACD is negative and declining further, then the negative gap between the faster moving average (green) and the slower moving average (blue) is expanding. Downward momentum is accelerating and this would be considered bearish. MACD centerline crossovers occur when the faster moving average crosses the slower moving average.
MACD is used to identify periods of divergence, wherein price action says one thing and MACD the exact opposite. This translates into a shift in momentum or the start of a trend reversal. Bearish (negative) divergence occurs when MACD makes new lows, while price reaches new highs (a sell warning). On the flip side, bullish (positive) divergence results from MACD making new highs, all the while price achieves new lows (a buy warning). The effect of divergence is further magnified at overbought/oversold levels. Higher level charts produce more robust indications of divergence. Look at the chart below.
Based on the chart above, the price will go up.
Do not use MACD for anything other than divergence. It is a lagging indicator, too slow for the Forex markets even though it may work well in other markets. In Forex, the MACD’s crossover with its signal will trigger ill-timed entry and exit points. It is recommended that you use MACD with other indicators such as trend line brerakouts, strong bar patterns, or a violation of a pivot point.