There are several ways to trade the capital markets. Finding the style that fits your trading personality is important as it will allow you to feel comfortable sticking with a trade. One of the easiest trading styles is trading using momentum. Momentum captures the flow of the market, and allows you to ride a wave while a trend is accelerating. There are many technical indicators that provide forex trading momentum, and one of the most popular is the moving average convergence divergence (MACD) index.
The MACD was created by Gerald Appel in the late 1970’s, and has been altered slightly over the past 40-years. The MACD attempts to capture momentum by evaluating the difference between two exponential moving averages.
What is an Exponential Moving Average?
A moving average is the average of specific prices over a certain period. For example, a 5-day moving average is the average of the past 5-days. On day 6, the first price is dropped from the average. An exponential moving average, weighs the more recent days heavier than the deferred days. This allows an exponential moving average to react at a faster pace compared to a standard moving average to price changes for a currency pair, security or commodity.
How is the MACD Calculated?
The MACD was created to evaluate the difference between 2-exponential moving averages and compare that difference to an exponential moving average of the difference. As the difference between 2-exponential moving averages increases, it tells you that momentum is beginning to accelerate. When the difference between 2-exponential moving averages is converging, momentum is decelerating.
There are two parts to the MACD. The index and the signal line. The default for the MACD index is the 12-day exponential moving average minus the 26-day exponential moving average. The default for the signal line is the 9-day exponential moving average of the index. There are no hard and fast rules for the number of days or weeks that you can use to generate a MACD index or signal line.
The MACD crossover is a momentum signal that is often used to pinpoint momentum. For example, the red arrow in June shows a MACD crossover where the MACD index (green line) crossed below the MACD signal line (blue line). This is a sell signal that reflects accelerating negative momentum. In July, a MACD crossover buy signal was generated. This occurs when the MACD index (green line) crosses above the MACD signal line (blue line).
Forecasting a MACD Crossover
The chart also shows a MACD histogram. This is the red distribution that shows the movements of the MACD index. What is important is the trajectory of the MACD histogram. As you can see in June the MACD histogram has a negative trajectory ahead of the MACD crossover which foreshadows accelerating negative momentum. The MACD histogram also shows you periods when positive or negative momentum is decelerating as the MACD histogram starts to peak or trough.
If you believe that you want to trade using momentum, then using the MACD to find crossover buy and sell signals, is an appropriate momentum tool to add to your trading arsenal.