TRADING Strategies

MACD divergences
short-term trades.
the correct side of the market. In early 1991, the first rally in the British pound to the 2.000 level was confirmed by the MACD, as indicated by the upwardsloping line 1. However, the second test of the same level in August 1992 corresponded with a negative divergence between the price and the MACD, indicated by the downward-sloping line 2. (A divergence occurs when price moves in one direction and the indicator moves in the opposite direction.) Longer-term divergences such as this can alert the

No matter what market you trade, taking

a top-down approach can save you from bad decisions. Heres how to use the MACD indicator to identify longer-term turning points that set up

BY GARY L. TILKIN

trader to potential weakness in the market. Had you reacted to this sign, you would have been ready when the free fall started.

lthough many stock traders believe short-term FIGURE 1 BIG PICTURE trading is a new phenomenon, its been The MACD divergence identified by line 2 on this monthly chart warned that the going on for years in the foreign British pound was ripe for a downturn. exchange (Forex) market. Unfortunately, many short-term Forex British pound, monthly traders (like stock traders) do not pay enough attention to the longer-term picture provided by monthly and weekly data. One reason monthly and weekly analysis is important is common technical studies such as the moving average conver gence-divergence (MACD) tend to give stronger signals when longer-term data is used. Well show how to use the MACD indicator to estab1 2 lish a top-down (long-term to short-term) analysis approach. Figure 1 (right), a monthly chart of the British pound with the MACD histogram (see Moving average convergence-divergence, 3/31/87 10/31/88 5/31/90 12/31/91 7/30/93 2/28/95 9/30/96 4/30/98 11/30/99 page 2), shows how starting with a Source: Strategem Software and Bridge Data long-term view will keep you on Copyright 2001 Active Trader magazine. Reprinted with permission from the June 2001 issue of Active Trader magazine (www.activetradermag.com).

As with most technical indicators, the most reliable MACD signals occur when the monthly, weekly and daily analyses are all in agreement. However, this is not always the case; a lack of agreement between the time periods may cause some traders to miss significant opportunities

2.0500 1.9800 1.9100 1.8400 1.7700 1.6300 1.5600 1.4900 1.4200 1.3500 0.0537 0.0337 0.0137 -0.0063 -0.0263 -0.0463

FIGURE 2 MONTHLY DIVERGENCES The longer-term divergences on the monthly Japanese yen chart provided advance notice of the major switch from downtrend to uptrend in 1995. or trade the wrong side of the market. To get a better feel for how to use the MACD, lets first set a few guidelines and then follow a sequence of events in the Japanese yen. The trending character of the currency markets lends itself to a top-down approach where the shorter-term trades are confirmed by the longer-term trend. Divergences in the monthly MACD signal the major trend has changed. Divergences in the weekly MACD histogram signal corrections within the major trend. Divergences in the daily MACD histogram also signal corrections within the major trend. However, trades against the long-term trend should be treated carefully. U.S. dollar/Japanese yen, monthly
162.0000 153.0000 144.0000 135.0000 126.0000 117.0000 108.0000 99.0000 90.0000 81.0000 72.0000 3.1187

2.1187 1.1187 0.1187

2 1
3/31/87 10/31/88 5/31/90 12/31/91 7/30/93 2/28/95 9/30/96 4/30/98 11/30/99

-0.8813 -1.8813 -2.8813

Source: Strategem Software and Bridge Data

Figure 2 (right) shows a long-term chart of the Japanese yen together with a monthly MACD histogram. From April 1990 to April 1995, the value of the yen rose 50 percent, when the exchange rate dropped from 160 to 80 yen per dollar. (For anyone not familiar with exchange rates, a simple way of looking at this is that in April 1990 it took 160 yen to buy one dollar; a few years later, it took only 80 yen.) Today you can trade the Forex market in $100,000 lot sizes, with leverage as high as 100 to 1, which means you can participate in the market with only a $1,000 margin requirement. (This increases both the profit potential and risk of trading in this market.) When the yen doubled in value to the dollar, it equaled a change in the exchange rate of 80 yen (160-80) or 8,000 pips, which is the Forex term for the smallest possible price increment. To calculate how much a one-pip move is worth in dollars, divide $1,000 with the current number of yen to the dollar. At the beginning of the above move each one-pip change was worth $6.25 (1,000/160); at the end of the move it was worth $12.5 (1,000/80); and on average over the entire period it was worth $8.3 (1,000/120). During this appreciation of the yen, the MACD formed its first divergence in 1993, shown by the upward sloping line 1.

This divergence continued to grow into 1995 (line 2). Double divergences, especially those formed over a two-year period when viewed using monthly data, are strong signs a major turning point is at hand. The dollar then rallied from 80 yen in early 1995 to 145 yen in June 1998. During this rally, the MACD formed an initial divergence in 1997, and a much stronger one in 1998, as indicated by line 3. At this point, even the shortest-term Forex trad-

er should have been warned that a shift in the overall bias, from being bullish the dollar to being bearish the dollar, was warranted. The ensuing decline that ended in the latter part of 2000 took the dollar back to the 100 area. Consequently, during the early 1995 to mid-1998 period, the monthly MACD told you to emphasize the long side and, more often than not, buy dollars and sell yen. Between mid-1998 and late 2000,
continued on p. 3

he moving average convergence-divergence (MACD) indicator, designed by Gerald Appel, is created by taking the difference between two exponential moving averages (default values of 12 and 26 days). An additional nine-day EMA is typically applied to the resulting oscillator to provide a signal line. Accordingly, the standard indicator is sometimes referred to as the 12-26-9 MACD. The MACD has a number of uses, including crossovers of the MACD and the signal line. Essentially, a buy (sell) is issued when the signal line crosses above (below) the MACD line. The difference between the MACD line and the signal line is sometimes plotted as a histogram below the actual MACD. This is simply an alternate way of representing MACD-signal line crossovers: When the histogram crosses above the median line, it represents the signal line crossing above the MACD line (a buy signal); the opposite is true when the histogram crosses below the median line. Also, divergences between the MACD and price can signal trend exhaustion (see Figures 1-4).

Moving average convergence-divergence

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FIGURE 3 WEEKLY DIVERGENCES

Weekly divergences help identify corrections within the major trend. The trick is to always put the weekly chart in the context of the longer-term, monthly chart.

reached the initial high levels of 1995. However, it did make marginally higher highs until August 1998, when the histogram formed an 154.0000 U.S. dollar/Japanese yen, weekly eight-week negative divergence 147.0000 (line 3). Looking back to Figure 2, 140.0000 you can see that the monthly 133.0000 MACD histogram formed a second 126.0000 major divergence at the same time. 119.0000 In keeping with the MACD guide112.0000 105.0000 lines, there was strong evidence of a 98.0000 significant turning point with both 91.0000 the weekly and monthly MACD 84.0000 signals working in tandem. 72.0000 Now, lets look at the daily data 2.1789 in Figure 4 (bottom left). Note that 1.2789 2 by early August 1998 the daily 3 0.3789 MACD histogram was forming a 0.5211 long-term divergence to the down-1.4211 side, as indicated by line 1. This 1 -2.3211 divergence later was confirmed by -3.2211 a shorter-term divergence (line 2), 8/6/93 5/6/94 2/3/95 11/3/95 8/2/96 5/2//97 2/6/98 11/6/98 8/6/99 which was given further weight Source: Strategem Software and Bridge Data when the MACD histogram dropped below the previous lows a sign of greater downside the monthly MACD favored the short MACD histogram during the yens initial side, which would have meant selling appreciation in the early 1990s. However, momentum. This is where those traders who focus dollars and buying yen the MACD is often misleading in strongsolely on the daily and intraday data ly trending markets. To its credit, it did most often interpret the MACD incorshow a strong burst of upside momenrectly. A trader who has missed a major tum on the dollars first rally in 1995. Line 1 in Figure 3 (above) shows there During the subsequent appreciation of rally often looks at the first daily divergence in the MACD histogram as a reawas no divergence formed by the weekly the dollar, the weekly MACD never son to trade the short side. But if the daily divergences are not FIGURE 4 DAILY DIVERGENCES accompanied by weekly divergences, as they were in this case Daily divergences must always be considered in light of what the weekly and monthly (see Figure 3), the corrections indicharts say. Look for opportunities where the signals on all three time frames are in sync. cated by the daily MACD are generally short-lived. They can be U.S. dollar/Japanese yen, daily 148.0000 traded by scalpers, but it is often 146.0000 better to set up new entries in the 144.0000 direction of the weekly and 142.0000 monthly trend. 140.0000
138.0000 136.0000 134.0000 132.0000 130.0000 128.0000 0.5872

0.1872 -0.2128

-0.6128 -1.0128

6/1/98

7/1/98

8/3/98

9/1/98

-1.4128

Source: Strategem Software and Bridge Data

Because the MACD indicator works like an oscillator based on a trend-following indicator (the moving average) it lends itself especially well to catch currency trends, both with and against the longer-term underlying trend. To make the most of this indicator, however, its important that you work with a top-down approach, always making sure you know what type of trending move you can expect within the context of the larger trend.

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