The technical tools used to analyse the wide range of movement in the markets come in many colours and creed. Each one on its own has a unique functionality and help in throwing up separate perspective of the currency market trade. While the debate on what is more effective and how can we use one tool over the another continues, one basic fact remains that technical tools form the backbone of trading and help traders prepare for eventualities and euphoria alike.
The topic, that we analyse in this session, is MACD Histogram. We have already talked about MACD indicator in some other articles (I will give you the links at the end of this article). What we want to focus on in this article is MACD Histogram. First a brief introduction about the indicator itself, and then more details about MACD Histogram.
What exactly do we understand by MACD? How does it differ from the usual moving averages chart and what comprise of the key highlights of this technical tool? At the very behest, let’s deal with the definition bit.
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Definition and History Of MACD
MACD stands for Moving Average Convergence Divergence. As the name indicates, this is a momentum indicator that follows the trend. In common terms you could term it as the crucial link that shows the relation between two moving averages. A simple way of calculating and deriving it is by using an existing 26 EMA (exponential moving average) and then subtracting it from a 12 EMA. As a direct derivation of that then is a 9 EMA is plotted on top of MACD. This then becomes the trigger to buy or sell your trading positions.
This was the description of “Traditional MACD” indicator:
What MT4 platform has by default, looks a little different. It only has the histogram and a 9 SMA:
Click Here to download and install the Traditional MACD on your MT4 platform if you like to follow it.
How to install the Traditional MACD on your MT4 platform:
Copy the indicator to the “Indicators” folder. To do that:
- Click on “File” menu at the top left of your MT4 platform.
- Click on “Open Data Folder”.
- Open the “MQL4” folder.
- Open the “Indicators” folder.
- Copy and paste the indicator to “Indicators” folder.
- Restart the MT4 platform.
- Open a price chart.
- Press Ctrl+N to open the navigator. Open the “Indicators” dropdown.
- Drag “traditional-macd-mt4” and drop it on the chart.
History of MACD
Understanding the historical relevance of this momentum indicator helps us get a better perspective. It was invented by Gerald Appeal in 1979. Widely appreciated by traders, the MACD has gained popularity since its inception essentially due to the simplicity in approach and the flexibility in interpretation and usage.
When you look at the typical MACD chart, you will see that there is one extra line which for all practical purposes can be interpreted as the EMA of the main MACD line. Essentially then the MACD histogram is an extremely elegant visual representation of the difference in price action between the MACD and the nine-day EMA plotted to arrive at the MACD. When you see the MACD above the 9-day EMA, you get a positive histogram. What it essentially mean sis that price rise leads to an increase in size of the histogram and it contracts in size as the price action sees a downward trend.
You can interpret the MACD in the following ways:
There are several ways that you can use this indicator to trade.
As a Crossover Signal:
Trader can identify crossover points when the MACD slips below the signal line indicating beginning of a bearish phase and signals a sell call. A positive or a bullish crossover is noticed when this same signal line rises above the MACD and gives the trader the sign to begin buying on the back of upward momentum.
When MACD lines cross each other, MACD Histogram also crosses the zero level:
The Divergence Signal:
You can safely conclude that the current market trend is coming to an end when you see the price action signaling a sharp divergence from the MACD. This is your indicator to wrap up existing positions and prepare for the ensuing trading position.
Well, as the name indicates MACD is about divergence as well as convergence of pricing action. The above explanations make us fairly aware of the divergence part and its many usages. However what do you mean by price convergence and how can you use it as a trader to reap benefits?
A convergence signal is formed when the market trend is pointing south. This is essentially a result of lower highs and even lower lows. At the same time, you will observe that the MACD bar goes up forming higher highs and higher lows. The convergence of the signal line with the MACD will be seen at the end of downtrend. That means as a trader a convergence is also a signal of reversal, but a trade should not be executed in a hurry.
However, the Divergence is a more popular tool for interpretation rather the Convergence on these charts. This is essentially because Divergence works more effectively as the market heads south and the correlation grows stronger. Fear anyway is a way stronger driver of market strategy compared to the greed. Hence fear and, as a result, its reflection as MACD divergence remains the dominant force of market action.
If you see a sudden sharp rise in the MACD, be cautioned. This is a signal indicating overbought conditions and the market needs to prepare for a return to normalcy shortly:
A sudden sharp fall in the MACD is a signal indicating oversold conditions:
The MACD moving above or below the zero line is yet another crucial indicator. Essentially this gives you the relative position of the short-term average with the long-term average chart. The MACD slipping below the zero signals the short-term average slipping below the long-term average, a clear bearish sign. No wonder the zero line can often be used as target support or resistance zone.
How To Interpret The Histogram?
In common parlance, we can look at the histogram as the difference between the final MACD that is plotted and the signal line that forms the base of it. It is generally plotted as bar charts behind the actual MACD line, and the height of the bar signals the difference between the signal line and the MACD.
The histogram is often a popular tool to trade the divergence using MACD. However, traders must be cautious that this divergence trade does not have a very high accuracy levels. It fails more times than it succeeds. The track record for signaling exit and entry into trading positions is way more dependable.
In other words, you can safely conclude that the MACD histogram is a fundamental reason for the wide spread popularity of the MACD as a momentum indicator. The speed of the price action is most frequently used to gauge the trend direction and as a sign of the future market move that is expected.
The MACD Histogram Used To Predict Entry & Exit Points
One of the most popular of the histogram, as we discussed in the previous paragraph, is resolving the potential anomaly between entry and exit points and helping the trader to clearly chart out points that he should identify as exit points and entry points for his trading positions. If this MACD histogram does not see the formation of a new swing generate a new swing high through the price action, the trader can continue to add to his existing position safely and looking to achieve a higher average price for potential shorts. On the other hand, a new swing high on the histogram point the vice versa or time to wrap up existing positions.
The reason, why this is a particularly popular indicator amongst traders, is because of the potential return scope when the price action reverses.
EUR/USD short trade setup formed by 2014.05.08 candlestick on the daily chart is one of the strongest trade setups formed in last several years. The downtrend that was started after this setup is still continued and has made over 2000 pips for the short position holders.
2014.05.08 candlestick formed a too strong Bearish Engulfing Pattern with a too strong Bollinger Upper Band breakout. When the next candlestick opened. MACD and signal line crossed MACD histogram crossed below zero level:
How the MACD Histogram Helps You Stay With the Trend
The possibility of yielding to fake signals is one of the biggest worries for a trader. The MACD indicator help you in safeguarding your trading positions from exactly this.
As a result of it being a lagging indicator, the signals come in delayed. Even when several other market indicator might be signalling beginning of a new trend or end of an existing one, the MACD by the sheer power of its delayed response ensures that you tide over all types of false alarms. Also, following the MACD ensures that you never enter or exit a trend too early. In return, this means your profit is preserved to a significant extent.
Also, divergence reflects a significantly accurate measure of the difference in price action and enables you to assess how removed the pricing is from the signal line. That in itself is a self-explanatory representation of the risk potential and profit perspective. Even without the aid of any additional tool you get a fair idea of the market action and the price pattern.
Another interesting part about being in trend is that risk or losses are never over analyzed. The MACD histograms work in a fashion that the trend is never compromised. It keeps a check on the price action as well as the time period of the trading strategy.
Since 2014.05.08 that this short trade setup formed, MACD and its signal line and also MACD histogram of MT4 default MACD are below zero level. It means the downtrend is still strong and bears can still hold their positions.
MACD Histogram: The Key Positives
That brings us to the usual pros and cons section analyzing the merits and demerits of the MACD Histogram. A look at the big advantages:
Its simplicity in approach and ease of plotting makes it a common and widely accepted to choice for a significant majority of users. Traders not only find it simple to understand but even to plot these when the trading platform that they use do not support it.
It is a highly flexible tool with easy adaptability across market conditions. Whether you are a seasoned market veteran or a novice in the market space, this is one tool you can always depend on to identify any potential trend in the market.
3. Visual representation:
The visual representation and the use of color make these histograms fairly simple to interpret and analyze. Whether you are a market analyst, a day trader or a hedge fund investor, across investor group, the MACD emerges as the winning choice for most who delve into analysis.
4. The game of patience:
Perhaps the MACD is a unique tool in its very approach. The nature of it is such that you are totally incapable of rushing into your trade whether it is to buy or sell. As a result of this, getting trapped into a false signal is fairly limited.
MACD Histogram: The Key Negatives
However for the effective execution of the trade using the MACD Histogram, traders have to pay attention to some key criterion. They must understand that there are some unique features of this indicator as a result of it being a lagging representation of market movement. No patience by far is the most significant area of concern. Most traders whose strategies see failure while using the MACD is because of the simple fact that they lose patience and rush to make alterations in their position on the back of the slightest price action.
Not just while entering, you need patience while exiting a MACD strategy as well. Let’s assume that you succeeded in taking on a favourable position in the market using this technical tool. Supposing you are in a hurry to exit and rush out even with a proportionately low profit figure, you end up being in the same position as you would be if you entered at an inappropriate point. The effort and the cost do not match, and the resultant return is significantly lower than expected.
Another important fact is that it is a lagging indicator and gives you delayed information. As a result of that you cannot execute any trade on a fast track course using it. Slow and steady is the mantra if you are using the MACD histogram. In case you are in a tearing hurry to alter, enter/exit your trading position, this is not a preferred tool. Even when other tools indicate a trade set up, MACD can ask to wait on.
LuckScout followers know that we normally don’t use indicators like MACD on our charts. We use candlestick patterns along with Bollinger Bands breakout to locate the trade setups. However, MACD is a great indicator for those novice traders who have not built their patience and discipline, and so they get in too early when there is no trade setup formed yet, and get out too early when the movement is not matured.
Time and again the importance of disciplined trade has been reiterated in the market place. The MACD Histogram in this context is a unique approach to trading your existing positions on the basis of the divergence in movement rather than the actual price action. The dynamics of the markets allows easy expansion of positions and makes it an equally lucrative position for traders and investors alike.
Any market veteran will always tell you that the trend is your friend. But the question is how you befriend the trend. Well, that totally is dependent on your ability to spot opportunities and devise strategies to maximize your gains from it. The MACD allows you to execute exactly that with extreme clarity and precision. As we all know, trading with the trend improves the odds in favor of the trader significantly.
The MACD, therefore, is not just a tool to maximize trend-spotting but also to optimize trend trading in a way that your profits are never compromised with. Also, the many colored MACD Histogram do not leave the scope for complicated analysis. Most of it becomes self-explanatory with a clear perspective on how the trend is expected to shape up in a matter of hours/days and the price points at which you need to prepare for potential reversal.