Trading And Understanding MACD Indicator
MACD is moving average convergence divergence which was created in 1979 by Gerald Appel (BTW, click here for our overview of the basics of technical analysis if you need that first). At the time he was among the most popular of the technical indicators in trading. The simplicity of this is appreciated by many traders around the world because it is simple and flexible. They use it as an indicator of momentum or trends.
One of the more popular ways to use this histogram is by trading divergence. The only problem with this is the fact that it's not very accurate which causes it to fail more than it succeeds. We think the more logical method is to use this for both trade entry and exit signals rather than only using it to look at the entry which is the more common way, and examining how traders of currency take advantage of that strategy.
The basic concept is pretty straightforward which makes it reasonably easy to get started. It requires calculating the difference between 12 and 26 Day Exponential Moving Average (EMA) to achieve a positive return. The faster choice is the 12 Day and that makes the 26 day is the slower choice. Both of these methods use the closing price during the period being measured. A nine-day EMA is plotted and it is used as a trigger to make buying and selling decisions. The Moving Average Convergence Divergence is considered a sign to buy if it goes above the 9 day Exponential Moving Average. If it goes below it then that is a signal to sell.
This histogram is a perfect visual representation of the differences between the MACD and the nine-day Exponential Moving Average. If the Moving Average Convergence Divergence goes above the nine-day Exponential Moving Average then it's positive and if it goes below it then it's negative and that tells the trader what to do. When prices are on the rise the histogram will grow bigger and this results in the price accelerating. The contracts then decelerate. When prices are falling then the principal works in reverse and these facts help the trader make profitable decisions.
This figure shows the histogram as the price accelerates and the lower part of the screen shows it making new lows. This particular histogram is why there are so many traders that rely on it as an indicator that measures momentum which they find helpful for decision making. It's a very good way because of how it responds to the movement and price and the speed of that movement. The typical trader uses it more often to determine the strength of the price move rather than the actual direction of the trend.
Trading Crypto Divergence
This is the classic way that traders use the MACD histogram as an indication of what they should do. They will find the chart points where the price makes a new movement, high or low, where the histogram doesn't. This is an indicator of divergence between the momentum and the price and this tells them what they should do. You'll see an illustration of this in figure 2.
Figure 2 shows a negative divergence trade. The price movement goes high as indicated at the right side circle but the other circle point fails to exceed its previous high. You'll find the high that the histogram reached by looking at the lower left side circle. The divergence shows that the price will soon reverse at the new high and that signals the trader that they should short the position.
This type of divergence trade is not accurate enough and that causes it to fail more often than it will succeed which is problematic. This is because prices will often have several final bursts in either direction which triggers stops which then forces a trader out of their position moments before the move actually takes a sustained turn allowing the trade to be profitable which is what is wanted. You'll see an example of this type of fake out in figure 3 which has been a great frustration too many traders over the years and continues to be a frustration.
Figure 3 depicts a typical fake out. The right circle illustrates a strong divergence near the bottom of the chart, close to the vertical line. Any trader who places their stops when the price swings high would be taken out of the trade before it would be able to be favorable for them. This, of course, prevents a profitable return and is, therefore, seen as a loser. The source of these charts is made possible by FXTrek Intellicharts.
How To Use The MACD Histogram With The Entry And Exit
It's possible to use the MACD histogram for entry and exit signals and doing so can resolve the inconsistencies which is what a trader wants. To do this requires trading the negative divergence by shorting the position at the beginning point of divergence. Then, instead of placing the stop where it swings high, it should be stopped out of the trade only if the high goes over its previous high. This is because that is an indication that the momentum is starting to accelerate and the trade was a wrong choice. If the histogram does not reach a new high then the trader can increase their position which allows them to get a higher average for their short. Using it this way is how it is a good strategy.
The ones that are best positioned to take advantage of this strategy are currency traders because it's advantageous to have a larger position because this increases the possible gains when the price reverses. In forex trading, it's possible to use this strategy with any size position without having to worry about having any impact on the price which is often difficult when using other strategies. It's possible to have transactions as big as a hundred thousand units and as little as a thousand units and the spread is usually three to five points.
A trader will have to average up even though the prices are temporarily going against them. The average investor considers this a bad strategy. There are some books on the subject that suggest this is just adding to your overall losers. Even so, there are good reasons for doing this strategy. When the histogram shows that divergence, it indicates that the price could soon turn. The trader is calling it a bluff and investing accordingly. An experienced trader can take advantage of the fixed costs in FX and they can withstand any temporary drawdowns and wait out the turn in price to their advantage. An example of this strategy is shown in figure 4.
The chart shows an example of the price reaching successive highs while the histogram does not. This is an indicator that a decline will come. When a trader averages up there short they can get a handsome profit. This is because the price will make a sustained reversal at the last point of divergence. We are always building out our academy pages to make sure there is relevant and useful information here for you, alot of this we ahve sourced from investopedia and made directly available to you here!
What's The Bottom Line?
There is no absolute black and white in trading. There are rules that traders typically follow on blind faith like the notion to never add a loser but doing so can allow for extraordinary profits. To do it successfully will require having a very logical approach if you're going to violate proven management rules for big gains. When using this strategy the MACD can indicate something different than the price offers and allow for trading divergence. It's a great way to scale up your position as a trader in the FX Market. Many Day Traders also find this an intriguing approach.
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