How To Trade The Forex Market Using MACD

 

MACD is an acronym for Moving Average Convergence Divergence. This indicator is used to identify moving averages that are indicating a new trend, whether it's bullish or bearish. Every trader’s top priority is being able to find a trend because that is where the most money is made. 

Question is:  How did they come about the name Moving Average Convergence Divergence?

Let’s start by explaining the concept behind this indicator.

When you load up a MACD indicator on your trading chart, you will usually see three numbers that are used for its settings.

• The first is the number of periods that are used to calculate the faster-moving average.

• The second is the number of periods that are used in the slower moving average.

• And the third is the number of bars that are used to calculate the moving average of the difference between the faster and slower moving averages. 

For example, if you open a MACD on your charting software, the parameters you would see are "12, 26, 9".  This is how you would interpret those numbers:

• The 12 represents the previous 12 bars of the faster-moving average.

• The 26 represents the previous 26 bars of the slower moving average.

• The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram.

The two lines that are drawn are NOT moving averages of the price. Rather, they are the moving averages of the DIFFERENCE between two moving averages.  

In the example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages.

The slower moving average on the other hand plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average. 

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average. If you look at the chart, you can see that, as the two moving averages separate, the histogram gets bigger. 

This is called divergence because the faster moving average is "diverging" or moving away from the slower moving average.

As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is "converging" or getting closer to the slower moving average. 

 Using The MACD

Because there are two moving averages with different "speeds", the faster one will obviously be quicker to react to price movement than the slower one. 

When a new trend occurs, the fast line will react first and eventually cross the slower line. When this "crossover" occurs, and the fast line starts to "diverge" or move away from the slower line, it often indicates that a new trend has formed.

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears. 

This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is a good indication of a strong trend.

Take a look at this chart below.

In the chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend would eventually reverse. 

From then on, the price began shooting up as it started a new uptrend. Assuming you bought this after the crossover, you would have made a good number of profits. 

There is one drawback to MACD though. Since all moving average lag behind price, because they calculate the average of historical prices, the same lagging is also expected of the MACD indicator also.

Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, the lagging is inevitable. However, MACD is still one of the most favored tools by many traders.

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How To Trade Forex Using Bollinger Band

 

Bollinger bands are used to measure a market's volatility. 

Basically, this little tool tells us whether the market is quiet or whether the market is loud! When the market is quiet, the bands contract and when the market is loud, the bands expand. 

Take a look at the chart below, you should notice that when price is quiet, the bands are close together and when price moves up, the bands spread apart.

The Bollinger band has its own calculations but you actually don't need to bother yourself with any of that.  Knowing how to apply this amazing indicator to your trading is actually more important.

 The Bollinger Bounce

One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce. By looking at the chart below, you can see that price did two things….

First, it touched the extreme part of the band, and then it went back down to the middle of the band…

The move you saw was a classic Bollinger Bounce. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels. 

The longer the time frame you are in, the stronger these bands tend to be. Some traders have developed systems that thrive on these bounces. A strategy like this is best used when the market is ranging and there is no clear trend.

The market also trends, so there are ways to equally trade a trending marketing using the Bollinger band indicator.

Bollinger Squeeze

The Bollinger squeeze is pretty self-explanatory, however when the bands squeeze together, it usually means that a breakout is getting ready to happen. 

If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then the price will usually continue to go down. 

Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Because it is breaking out the top band, the possibility is very high that it will continue going up prompting an upward trend.

That was exactly what it did if you now look at the image below.  

This is how a typical Bollinger Squeeze works. 

This strategy is designed for you to catch a move as early as possible. Setups like these don't occur every day, but you can probably spot them a few times a week if you are looking at a 15-minute chart. 

There are many other things you can do with Bollinger bands, but these are the 2 most common strategies associated with them. This is basically the information you need to start with on Bollinger band and with constant practice with this indicator; you would be able to come up with other unique ways to work with it.

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How To Use Moving Average In Forex Trading

 

A moving average is simply a way to smooth out price action overtime.

Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can better determine the potential direction of market prices. 

As we said, moving averages smooth out price action. 

There are different types of moving averages and each of them has their own level of "smoothness". 

Generally, the smoother the moving average, the slower it is to react to the price movement. 

The choppier the moving average, the quicker it is to react to the price movement. To make a moving average smoother, you should get the average closing prices over a longer time period.  

In this section, we first need to explain to you the two major types of moving averages:

1. Simple

 2. Exponential

It’s important you know how to calculate them and give the pros and cons of each. It’s of great benefit for you to know the basics first.  

So let me dive into it right away.

 

Simple Moving Averages

A simple moving average is the simplest type of moving average.

Even though you won’t be needing to calculate what I am about to explain now because the software will automatically do that for you, I just want to give you a heads up so you know what is happening behind the software when you plot it on your chart.

 Here we go..

A simple moving average is calculated by adding up the last "X" period's closing prices and then dividing that number by X. 

Lost?

Just read along.

IMAGE OF WHAT A MOVING AVERAGE LOOKS LIKE ON A CHART.

If you plotted a 5 period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5. Voila! You have the average closing price over the last five hours! String those average prices together and you get a moving average!

That’s what it does.

If you were to plot a 5-period simple moving average on a 10-minute chart, what the software does is to add up the closing prices of the last 50 minutes and then divide that number by 5. 

If you were to plot a 5 period simple moving average on a 30 minute chart, the software adds up the closing prices of the last 150 minutes and then divides that number by 5.

If you were to plot the 5-period simple moving average on the 4 hr, the software adds up the closing prices of the last 20hours and then divides that number by 5.

You get the picture!

All Forex platforms will do the calculations for you. The reason I explain it as background information is for you to understand so that you know how to edit and tweak the indicator when you start using it.

Understanding how an indicator works means you can adjust and create different strategies as the market environment changes. 

Now, just like almost any other indicator out there, moving averages operate with a delay. Because you are taking the averages of past price history, you are really only seeing the general path of the recent past and the general direction of "future" short term price action. 

Here is an example of how moving averages smooth out the price action

On the chart above, I plotted three different Simple Moving Averages on the chart. 

The longer the SMA period is, the more it lags behind the price. 

Notice how the 50 SMA is farther away from the current price than the 20 and 10 SMAs. 

This is because the 50 SMA adds up the closing prices of the last 50 periods and divides it by 50. The longer period you use for the SMA, the slower it is to react to the price movement. 

The SMAs in this chart shows you the overall sentiment of the market at this point in time. Here, we can see that the pair is trending. 

Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now gauge the general direction of its future price. With the use of Simple Moving Averages, we can tell whether a pair is trending up, trending down, or just ranging. 

There is one problem with the simple moving average and it's that they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new trend may be developing but in reality, nothing changed.

Let’s take a look at another type of moving average.

Exponential Moving Average

So while the simple moving average places emphasis on the closing of prices which makes it a bit slow but gives us the general trend, the exponential moving averages (EMA) give more weight to the most recent periods. It puts more emphasis on what traders are doing recently. 

Let's take a look at this chart to highlight how an SMA and EMA would look side by side on a chart.

 Notice how the red line (the 50 EMA) seems to be closer to the price than the blue line (the 50 SMA). This means that it more accurately represents recent price action.

It's because the EMA places more emphasis on what has been happening lately. When trading, it is far more important to see what traders are doing at the moment rather than what they were doing last week or last month.

 SMA vs. EMA

Let me quickly explain the difference between the two.

First, let's start with the exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go. 

These can help you catch trends very early, which will result in higher profits. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits.

The downside to using the exponential moving average is that you might get faked out during consolidation periods. 

Because the moving average responds so quickly to the price, you might think a trend is forming when it could just be a price spike. This is because the indicator is just too fast.  

With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go. 

This would work well when looking at longer time frames, as it could give you an idea of the overall trend.

Although it is slow to respond to the price action, it would do well in saving you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good entry price or the trade altogether.

 So which one is better?

This is left to the trader to decide based on what they want to see in the price.

Traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade. 

There are a number of trading strategies that are built around the use of moving averages. I will be taking a look at these in the following lessons.

I will teach you on:

1. How to use moving averages to determine the trend

2. How to incorporate the crossover of moving averages into your trading system

3. How moving averages can be used as dynamic support and resistance

 Using Moving Averages

One sweet way to use moving averages is to help you determine the trend. 

The simplest way is to just plot a single moving average on the chart. When price action stays above the moving average, it would signal that price is in a general uptrend. 

If price action stays below the moving average, then it would indicate that it is in a downtrend

 What the majority of traders do - and what I suggest you do as well - is that they plot a combination of moving averages on their charts instead of just one. This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages. 

Let me explain. 

In a downtrend, the "faster" moving average should be below the "slower" moving average and for an uptrend, vice versa. For example, let's say we have two SMAs: the 20-period SMA and the 100-period SMA. On your chart, it would look like this:

Moving Average Crossover Trading

By now, you know how to determine the trend by plotting on some moving averages on your charts. You should also know that moving averages can help you determine when a trend is about to end and reverse. 

All you have to do is to load up a couple of moving averages on your chart and wait for a crossover. If the moving averages cross over one another, it could signal that the trend is about to change soon, thereby giving you the chance to get a better entry. By having a better entry, you have the chance to profit from the trade.

Note, when price is trending downwards or upwards for an extended period of time, you would make money using the moving average crosses has your entry points. But when the price is trending sideways which we get to experience sometimes, then the crosses won’t be effective because you would experience multiple crosses that won’t lead anywhere.

                          Moving Average acting as Support and Resistance

Moving averages can also be used as a support and resistance level.

Due to the fact that the moving average works alongside the price and not static like your traditional support and resistance, it is referred to as dynamic support or resistance.  They are constantly changing depending on recent price action. 

Some traders look to moving averages as key support or resistance. These traders will buy when the price dips and tests the moving average or sell if the price rises and touches the moving average. 

Take a look at the chart below.

It looks like it held really well! Every time price approached the moving average and tested it, it acted as resistance and price bounced back down.

One thing you should keep in mind is that these are just like your normal support and resistance lines.

There are also times when the price will blast past it altogether and won’t acknowledge the moving average.

 Breaking through Dynamic Support and Resistance

Now you know that moving averages can potentially act as support and resistance. Combining a couple of them, you can have yourself a nice little zone. But you should also know that they can break, just like any support and resistance level! 

Let's take another look at the chart below.

In the chart above, we see that the 50SMA, 100SMA, and 150SMA held as a strong resistance level for a while as price repeatedly bounced off it. 

So there you have it, folks!

Moving averages can also act as dynamic support and resistance levels. 

One nice thing about using moving averages is that they're always changing, which means that you can just leave it on your chart and don't have to keep looking back in time to spot potential support and resistance levels. 

Why don't you open up your charting software and try popping up some moving averages here.  

Remember, using moving averages is easy. The hard part is determining which one to use! 

That's why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want to use them as dynamic support and resistance. 

Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan. 

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Understanding Support and Resistance in Forex

 

Support and resistance is one of the most widely used concepts in trading. It's extremely popular amongst traders. There are several ways to measure support and resistance designed by a lot of traders. Here is a look at the basics.

 

Look at the diagram above. As you can see, this zigzag pattern is making its way up (uptrend). When the market moves up and then pulls back, the highest point reached before it pulled back is now resistance.

As the market continues up again, the lowest point reached before it started back is now support. In this way, resistance and support are continually formed as the market oscillates over time. The reverse is true for the downtrend.

Plotting Support and Resistance

One thing to remember is that support and resistance levels are not exact numbers. 

Often times you will see a support or resistance level that appears broken, but soon after find out that the market was just testing it. With candlestick charts, these "tests" of support and resistance are usually represented by the candlestick shadows.

Notice how the shadows of the candles tested the support level. At those times it seemed like the market was "breaking" support. In hindsight, we can see that the market was merely testing that level.  

 

So how do we truly know if support and resistance was broken?

There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case. 

Let's take our same example from above and see what happened when the price actually closed past the support level.

In this case, the price had closed below the support level but ended up rising back up above it. 

If you had believed that this was a real breakout and sold this pair, you would've been wrong.

Looking at the chart now, you can visually see and come to the conclusion that the support was not actually broken; it is still very much intact and now even stronger. 

To help you filter out these false breakouts, you should think of support and resistance more of as "zones" rather than concrete numbers. 

One way to help you find these zones is to plot support and resistance on a line chart rather than a candlestick chart. The reason is that line charts only show you the closing price while candlesticks add the extreme highs and lows to the picture. 

These highs and lows can be misleading because often times they are just the "knee-jerk" reactions of the market.

When plotting support and resistance, you don't want the reflexes of the market. You only want to plot its intentional movement

Looking at the line chart, you want to plot your support and resistance lines around areas where you can see the price forming several peaks or valleys. 

Other interesting tidbits about support and resistance

When the price passes through resistance, that resistance could potentially become support.

The more often price tests a level of resistance or support without breaking it, the stronger the area of resistance or support is.

When a support or resistance level breaks, the strength of the follow-through move depends on how strongly the broken support or resistance had been holding. 

With a little practice, you'll be able to spot potential support and resistance areas easily. Now let’s look at how to draw trendlines.

 

Trend lines

Trend lines are probably the most common form of technical analysis. They are probably one of the most underutilized ones as well.

If drawn correctly, they can be as accurate as any other method. Unfortunately, most traders don't draw them correctly or try to make the line fit the market instead of the other way around.

In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas (peaks).

How do you draw trend lines

To draw trend lines properly, all you have to do is locate two major tops or bottoms and connect them. 

Here are trend lines in action! Look at those waves!

Types of Trends

There are three types of trends:

Uptrend (higher lows)

 Downtrend (lower highs)

Sideways trends (ranging)

 

Here are some important things to remember about trend lines:

It takes at least two tops or bottoms to draw a valid trend line but it takes THREE to confirm a trend line.

The STEEPER the trend line you draw, the less reliable it is going to be and the more likely it will break.

Like horizontal support and resistance levels, trend lines become stronger the more times they are tested.

And most importantly, DO NOT EVER draw trend lines by forcing them to fit the market. If they do not fit right, then that trend line isn't a valid one!

 

Channels

If we take this trend line theory one step further and draw a parallel line at the same angle of the uptrend or downtrend, we will have created a channel.

Channels are just another tool in technical analysis which can be used to determine good places to buy or sell. Both the tops and bottoms of channels represent potential areas of support or resistance.

To create an up (ascending) channel, simply draw a parallel line at the same angle as an uptrend line and then move that line to position where it touches the most recent peak. This should be done at the same time you create the trend line.

To create a down (descending) channel, simply draw a parallel line at the same angle as the downtrend line and then move that line to a position where it touches the most recent valley. This should be done at the same time you create the trend line. 

When prices hit the bottom trend line, this may be used as a buying area. When prices hit the upper trend line, this may be used as a selling area. 

Types of channels

There are three types of channels:

Ascending channel (higher highs and higher lows)

Descending channel (lower highers and lower lows)

Horizontal channel (ranging)

Important things to remember about trend lines:

When constructing a channel, both trend lines must be parallel to each other. 

Generally, the bottom of the channel is considered a buy zone while the top of the channel is considered a sell zone.

Like in drawing trend lines, don’t force the price to the channels that you draw! A channel boundary that is sloping at one angle while the corresponding channel boundary is sloping at another is not correct and could lead to bad trades.

Trading the Lines

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How To Use Forex Trading Indicators

Forex technical indicators are used to forecast price changes on the currency market. They can also be used to know when to enter the market for a trade. Forex MetaTrader 4 trading platform allows you to place indicators on your chart which can help you to make informed trading decisions based on your accurate use and understanding of these indicators. Most professional traders use them and you should also. 

Note - If you would like to know what online forex trading is all about before proceeding with the class below, you can find out here. 

I would be explaining 9 types of indicators in this section. Take a look at them in the list below. Just click on the one you like to learn about.

Support and resistance is one of the most widely used concepts in trading. It's extremely popular amongst traders. Click here to learn more..

A moving average is simply a way to smooth out price action over time. Like every indicator, a moving average indicator is used to help us forecast future prices. Click here to learn more..

Bollinger bands are used to measure a market's volatility. Basically, this little tool tells us whether the market is quiet or whether the market is loud! Click here to learn more..

MACD is an acronym for Moving Average Convergence Divergence. This indicator is used to identify moving averages that are indicating a new trend, whether it's bullish or bearish. Click here to learn more..

 

One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal). Click here to learn more..

The Stochastic is another indicator that helps us determine where a trend might be ending. The stochastic has two lines that cross each other to give a sell or a buy signal. Click here to learn more..

Relative Strength Index (RSI) shares similarities with other oscillators because it is designed to identify overbought and oversold conditions in the market. It is also scaled from 0 to 100. Click here to learn more..

The Average Directional Index, or ADX for short, is another example of an oscillator. ADX is typically used to identify whether the market is ranging or starting a new trend. Click here to learn more..
 

 

Fibonacci is a huge subject in the world of trading. Lot of traders use the Fibonacci retracement levels as potential support and resistance areas. Click here to learn more..
 

Now that you know how to use indicators to trade, you can open a forex account here and start trading. 

Like to take your trading to the next level. Enroll in the Forex Apprentice Class.