The MACD Indicator
MACD stands for for Moving Average Convergence Divergence and it is what is known as a lagging indicator. The MACD indicator is a useful tool for confirming when trends have formed or may be reversing. It does this by plotting the relationship between two moving averages.
The settings are usually expressed as three numbers. Commonly you might see 12,26,9. The first two numbers (12 and 26) indicate the number of periods used to calculate two moving averages. The faster moving average line, which is often green on the chart, measures the moving average of the difference between the 12 and the 26 period moving averages.
The slower moving average line is often red on the chart. This line plots the average of the last 9 (or whatever is the third number) periods of the faster moving average line. It usually shows smoother curves because its effect is to smooth out the fast moving average line. The histogram that measures convergence and divergence is the series of blocks stretching above and below an axis near the bottom of the chart. This simply records the difference between the faster and slower moving averages.
During convergence, you will see the two lines on the chart approaching each other and the bars on the histogram at the bottom of the chart become smaller. This usually indicates that the current trend is coming to an end or has ended.
Of course the faster line reacts to a change in price movements more quickly than the slower line. So when a new trend forms, the faster line will get closer and finally cross the slower line. If it then separates or diverges from the slower line, this is often an indicator that a new trend has formed.
When the two lines cross, the bars of the histogram will be at zero and then cross their axis so that if they were below the axis before, they are now above it, and vice versa. If a strong new trend is forming, the bars will quickly lengthen in the new direction.
So this crossover could be used as a signal to place an order. You have a buy signal when the faster line crosses the slower line from below, and a sell signal when it crosses from above.
However, there are disadvantages to the MACD which make the crossover unreliable as a self standing signal. The main problem is that even the so-called fast line lags significantly behind actual prices because it measures averages of the past prices. So when the market is very volatile, trends could be ending before the MACD crossover marks that they have begun.
Generally the MACD is a better indicator of the strength of a trend than it is of its direction. For this reason some traders ignore the crossover and look instead at the length of the histogram bars.
If you decide to trade the MACD, you should probably use it for both your entry and exit signals. This takes a lot of nerve and experience, and it is not recommended for beginner forex traders. So if you are just starting out, you are probably better advised to base your trading decisions on other indicators and refer to the MACD only for confirmation.
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