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The MACD indicator is a popular oscillator indicator that will give you an ideal on when momentum is shifting and when a trend reversal could possibly take place. As currency traders, we should always trade on the side of the trend. We do not want to fight against the trend and find ouselves on the losing end of a trade. This is why knowing when a trend reversal will take place is crucially important. The MACD oscillator indicator provides us with that information so that we can decide if it’s best to enter a trade or not.
As stated before, the MACD indicator is great for knowing when divergence is taking place. Divergence is when the price of an asset moves in the opposite direction of an indicator or other related asset. For example, if an indicator is signaling a momentum change to the upside, while price is still moving to the downside, that is divergence. Whenever the market is in divergence, we typically want to “stand on the sidelines” and not enter any trades during this potential reversal of the trend. When the market is in divergence, we do not know where sentiment lies at that particular moment. The momentum in the market, at that time, is “murky” or unclear. Also when divergence is taking place, the market can just be in a correction before price continues in the direction of the over-arching trend for the day. So it’s always best, and safer to wait until price action fully forms so that we can be confident on where the market bias or trend truly is. We do not want to prematurely assume that a trend reversal is taking place, especially when that reversal could be a short correction or pullback in price. I discuss this in better detail within our 3% per day compounding trading strategy. Now there are 3 methods for interpreting the MACD indicator.
1. Crossovers – The MACD indicator is composed of two exponential moving averages, a fast moving average and a slow moving average. The common default for these moving averages (EMA’s) is at a period of 12 and 26. However, the MACD line is actually the difference between the two exponential moving averages (12 EMA – 26 EMA). There is also a 3rd parameter called the ‘signal line’ that has a period of 9. When using the crossover method, we are identifying the times when these moving averages cross each other on the MACD indicator. When the MACD line crosses beneath the signal line(9), it’s a bearish signal. When the MACD line crosses above the signal line(9), it indicates a bullish signal. Traders typically wait for further confirmation by seeing if the MACD line fully crosses the signal line before they enter a trade position. Although this is a commonly used approach when trading with the MACD indicator, we personally do not use this MACD method when trading our unique forex trading Strategy.
2. Divergence – This is when the price of an asset or currency diverges from the MACD indicator. When this happens, it indicates a possible trend reversal. This is the way that we use the MACD indicator. We strictly use if for identifying divergence.
Sidenote: Any momentum oscillator can help you identify when divergence takes place. The MACD indicator, helps make it a little bit easier to identify though. I suggest that you sign up for our free video report and receive information on exactly how we trade divergence using MACD and other momentum oscillators.
3. Dramatic Rise – This is when the MACD line rises suddenly and sharply, and begins to move further away from the signal line. This indicates that the market is overbought and that we should expect a correction in the market.
Above, are 3 common methods for using the MACD indicator when trading financial markets. We only use the MACD indicator for divergence information only. As stated above, it is imperative that you understand when a trend reversal is taking place so that you can trade in the direction of the trend. Research has shown, that you are at a statistical advantage when you trade with the trend. Therefore, we ALWAYS want to identify when the trend is changing so that we can either exit from an open trade position, or “sit on the sidelines” until the new trend fully forms.
But when the trend forms, what do we do next?
You still have to understand when and how to execute a precise entry in the market after a divergence or trend reversal takes place. My recommendation, is that you do what a single mother did and learn how to analyze the market for precise entries using a unique mechanical price action strategy.
Melvin Perry has been trading the Forex market since 2010. Like his brother, he attended the University of Illinois in Urbana-Champaign and graduated with a BS in Bioengineering in 2002. Although an active trader, he spends most of his time reading the Bible, studying the markets and providing content for this blog. He also does an average of two training webinars a week with the Slumdog Forex VIP community.