Gerald Appel developed the MACD indicator, and it is simply a method of identifying the potential for two exponential moving averages to cross. MACD is calculated using a short length and a long length exponential moving average (defaulted to 12 and 26) and calculating the difference between these two averages. In other words, it is the spread between the two averages.
Normally, a signal line is derived by calculating an exponential moving average of the MACD. You can also have the MACD displayed as a histogram – a series of vertical bars above and below a zero line
Crossovers of the MACD and signal lines identify shifts in the balance of power of bulls and bears.
Trading in the direction of a crossover means going with the flow of the market
When the fast MACD line crosses above the slow signal line, it gives a buy signal. Go long, and place a protective stop below the latest low. See A above.
When the fast line closes below the slow line, it gives a sell signal, and places a protective stop above the latest minor high. See B above.
MACD HISTOGRAM
The MACD Histogram gives a more in-depth guide to the balance of power between bulls and bears, and tells us if the bulls and bears are getting stronger or weaker. In my opinion one of the best tools. In the above chart, you can see that just before point A, the bears are losing the momentum.
MACD- HISTOGRAM and PRICE DIVERGENCES
Divergences between MACD- Histogram and prices identify major turning points. These signals do not occur often, but when they do, they often let you catch major reversals and the beginning of a new trend.
In my opinion the MACD divergence is probably the strongest signal in Technical Analysis. You could probably make a living trading the divergences only! MACD should be a copycat of the price action, and therefore macd will also make a higher high same as a price action, if this pattern is not repeated then you have a divergence.
When prices rally to a new high, but MACD traces lower, this is a bearish divergence, this shows that the bulls are getting weaker, this would identify a price weakness at market tops.
The following is an example of a Bearish Divergence.
Another example of a perfect MACD Bearish Divergence A possible entry at 1.8670,
The EMA crossover at 1.8295 will still keep you in this trade; at this point the profit from the trade was 375 pips.
You could consider closing the position at 1.7970 when the 20 EMA starts to rise, this giving a profit of 700 pips.
At this stage the 20 EMA has not crossed over the 60 EMA, so some of you may want to carry on with the trade. If you did so then you would have had a perfect opportunity to close the trade at the Double bottom on 7/10/04 at 1.7760 – giving a total of 910 pips profit.
Not a bad trade, from divergence.
MACD BULLISH DIVERGENCE
If the prices fall to a new low but MACD traces a more shallow low, it would mean that bulls are ready to gain control, and this would identify strength at market bottoms. This is a Bullish divergence. They give buy signals when most traders feel fearful about a breakdown to a new low!
The following chart illustrates a perfect MACD Bullish divergence on a EURUSD Chart
You could consider longs when the MACD Histogram ticks up from its shallower bottom; while prices are at a new low, place a protective stop below it’s latest low.
The higher the time frame of a chart in which the MACD divergence occurs, this may result in a larger move.
For example in the above chart, at around 1.2250 the peak of that rally had been 1.2850 – thereby giving an overall gain of 600 pips. In this instance your entry points were much earlier than the EMA 5/60 day crossover
All the above strategies will work in any time frame, so unlike me, if you enjoy the thrills and excitement of watching your screens for every second to catch 20 to 30 pips per trade, then you can certainly switch the charts to a lower time frame, i.e. 1 minutes or 5 minutes.
Relative Strength Index (RSI)
The relative strength Index (RSI) is a momentum-based indicator. Determining the true value of an oscillator depends on the understanding of overbought or oversold positions. The basic formula for calculating RSI is as follows:
100-(100/(1+U/D)
U = average upward price change D = average of downward price change
RSI as an indicator is front weighted i.e. it gives more importance to more recent price action. It gives a better velocity reading than other oscillators; it also tends to filter out lot of noise. Your software should be able to do the work for you.
At the bottom of the chart below, the RSI, on a scale of 0 to 100, indicates that the overbought position is at 70 and oversold position is at 30. Some traders use the 80/20 range, as they do not want to pull the trigger too fast!
Some traders also use the short term moving average crossovers, this will also indicate a shift in direction, and when this occurs when the RSI is at extreme levels then it could be a powerful set-up to pull the trigger.
There are 5 different uses for RSI;
1. Tops and bottoms – overbought and oversold conditions are usually signalled at 30 and 70.
2. Divergences – when a pair makes new highs or lows, but the RSI does not follow price action, this usually indicates that price reversal is coming.
3. Support and Resistance – RSI may show levels of support and resistance, sometimes more clearly than the price chart itself.
4. Chart Formations – Patterns such as double tops and head and shoulder may be more visible on RSI rather than on price charts
5. Failure swings – when RSI breaks out, i.e. it surpasses previous high or low, this may indicate that a breakout in price is coming.
It is important to understand that an overbought or oversold position can remain in an extended up trend or downtrend for some time, so try and use other methods combined with RSI, rather than using it on its own.
In the above chart, RSI was useful in detecting a short trade after a divergence and also a crossover of the 70 “ overbought” level. The above chart is a 5-minute time frame. There are at least 2 good short trades.
On the long side, notice the RSI bouncing just around the 30 oversold, subsequently there is a double bottom, and a divergence on the RSI. This was around the price level 1.880.
Having a closer review of the above 5-minute chart, which covers a two-day period. The GBP has not moved much, yet there were few opportunities to trade both from the long side as well as short, with a gain of more than 100 pips.