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MOVING AVERAGE CONVERGENCE -DIVERGENCE On FOREX Market
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In simplest terms, moving average convergence/divergence (MACD) is an indicator that shows when a short-term moving average crosses over a longer-term moving average. Gerald Appel developed this indicator as we know it today, and he developed it for the purpose of stock trading. It is now widely used for short-term trading signals in stocks, futures, and forex markets, as well as for swing and position traders. It is composed of using three exponential moving averages. The initial inputs for the calculations were the difference between a 12-day and a 26-day exponential smoothed average. The signal line used is a 9-day smoothing of today's MACD value, subtracted from the last time period's MACD value. Most charting packages give the 12-period and 26-period averages and use the smoothed average of a 9-period average for the signal line.

There are many variations, and most charting software packages allow you to change the parameters. Just remember that the fewer time periods you input, the more sensitive the indicator will be to price changes. There fore, with fewer time periods, an indicator will generate more signals. Longer time periods help smooth out the false crossover signals. Some variations to consider are using 10-period and 24-period averages and an 8 period input for the smoothed average signal line.

The concept behind this indicator is to calculate a value that is the dif ference between the two exponential moving averages, which then compares that to the 9-period exponential moving average. What we get is a moving average crossover feature and a zero-line oscillator, and that helps us to identify overbought and oversold market conditions. These moving average crossovers also show us shifts in momentum that help identify buy and sell signals, as Figure 5.6 illustrates.

I might add that since traders are now more computer savvy than ever before, many charting software packages allow changing or optimizing the settings or parameters. In other words, it is easy to change, or tweak, the variables in original calculations. Traders can increase the time periods in the moving average calculations to generate fewer trade signals and can shorten the time periods to generate more trade signals. Just as is the case for most indicators, the higher the number of time periods used, the less sensitive the indicator will be to changes in price movements.

MACD signals react quickly to changes in the market, and that is why a lot of analysts, including myself, use it. It helps clear the picture when mov ing average crossovers occur. Figure 5.7 shows that where the moving av erages cross over at corresponding low points on the chart, a bullish convergence develops as prices make a lower low but the moving average component makes a higher low. Since MACD measures the relative strength between current prices as compared to past time frames, giving a short-term perspective relative to a longer-term perspective, we are able to detect internal changes in the market, such as a bullish reversal.

Here are a few general points to help you understand how to use this in dicator: When the fast line crosses above the slow line, a buy signal is gen erated; the opposite is true for sell signals. The MACD also has a zero-baseline component called the histogram that is created by subtract ing the slower signal line from the MACD line. If the MACD line is above the zero line, prices are usually trending higher. The opposite is true if the

MACD is declining below the zero line. The MACD is a lagging indicator be cause it is based off moving averages. We want to look for the zero-line crossovers to identify market changes and to help confirm trade entries or to trigger action to exit a position. Watching for clues that identify shifts in momentum as the market moves from one extreme to another or from overbought to oversold to trigger a trading opportunity can be identified with the aid of MACD readings in both the moving average and the his togram component. While it is more profitable in buying the absolute bot tom, that is a haphazard guessing game to play.

Trading based on a set of rules and being able to use a confirming indi cator to identify a change in price direction and then following that price movement is the essence of how to make money in the markets. The guide lines for taking buy and sell signals using bullish and bearish divergence as described at the beginning of the chapter can also be applied using MACD. However, with the MACD, we can see the convergence and divergence in the moving average lines. These convergence bottoms and divergence top patterns form more often in the histogram bars. But you absolutely need to pay attention to the moving average component, which can act as an ex cellent guide in detecting shifts in momentum. The key to effectively trad ing bullish convergence or bearish divergence patterns is that they must occur within a relatively short period of time. For example, on a daily chart, you would want to see a pattern form within 30 days.

Take, for example, the daily chart in Figure 5.8 of the spot Swiss franc. The MACD histogram helped identify a bullish divergence pattern, but the moving average component rally stood out as identifying the reversal. See how the secondary low on the price chart was significantly lower than the first low, while the corresponding lows of the moving average component of the MACD made higher highs. The pattern in the MACD was a higher right-side double bottom, while the actual price made a lower low. When a convergence like this develops on a daily chart pattern, day traders should be using a shorter time period to take buy signals within a newly formed uptrend. Signals like these will keep you on the right side of the market. Using convergence and divergence signals from higher time frames is a very powerful methodology for finding high-probability trading opportuni ties for short-term traders. If there is a bullish trend reversal signal that is clearly identified using stochastics or an MACD indicator on a daily chart, then you want to look for corresponding buy signals on the 60- or 15minute time frames.

Looking at Figure 5.9 in the Canadian dollar, you should notice that the top pattern peaks with a corresponding lower double-top pattern within the MACD moving average component. The process took less than one month to form and, as such, met the criteria that a bearish divergence pattern formed. Now traders can seek out shorter-term sell signals.

Markets spend a majority of the time in consolidation phases and have a tendency to explode in a breakout trend in relatively short order. This price behavior occurs while the majority of traders are either on the side lines or on the wrong side. That is why I prefer stochastics over the MACD study. The fast stochastics indicator generally gives confirmation on trig gers earlier than the MACD studies do. In the chart in Figure 5.10, notice that the high close doji triggers a buy that is confirmed and is in sync with the stochastics signal. The MACD triggers substantially later.

Let's examine this relationship more closely by studying the euro cur rency chart in Figure 5.11. The pivot point system signals are more in line with the cycles of the stochastics as the MACD confirms price reactions much later. This is not bad; it is just that the pivot point moving average component and stochastics are better. As I have previously stated, markets move in cycles, from trend to consolidation; as such, the aid of these two in dicators will give you a better read on market conditions. It is reasonable to believe that as prices move, using both indicators will allow you to identify whether you are in the beginning of a trend or closer to the end. That is what will help you to be more selective in your trades. Add to this mix of studies the ability to understand the psychology behind candle patterns, and your reaction to market behavior should improve greatly. See how the tweezer top formation on this 30-minute chart corresponded with a sto chastics bearish divergence and how, as the trade system gave a sell signal, the stochastics %K and %D both closed back under the 80 percent line. The MACD gives a valid confirmation. but unfortunately it gives a signal nearly 40 PIPs (percentage in points) late. That difference alone can define what makes a profitable day trade versus an unprofitable one.

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