Learn more about how to use indicators in creating trading strategies at FX Academy.

By: Richard Cox

One of the most common technical indicators that is used by day traders in the financial markets can be seen in the Moving Average Convergence Divergence — more commonly referred to as the MACD. But one mistake that many new traders make is that they will simply start using this indicator without really understanding how it functions or makes its calculations. This can lead to costly mistakes that should have been completely avoidable. So, it makes sense to study the logic and calculations behind the MACD (and all other indicators) in order to more accurately configure your day trading positions and generate gains on a consistent basis.

The Moving Average Convergence Divergence (MACD) Defined

Anyone with any experience in the forex markets and in technical analysis strategies has likely heard a great deal about the Moving Average Convergence Divergence (MACD). But what exactly does the MACD tell us — and how is it calculated? Without an understanding of these areas, it can be difficult to see trading signals as they emerge. Here, will deconstruct the MACD indicator and explain how and why it is commonly used.

In its most basic form, said Haris Constantinou, markets analyst at TeleTrade, the MACD is a momentum indicator that is designed to follow existing trends and find new ones. The MACD does this by showing the differences and relationships between a two-level combination of moving averages and price activity itself.

MACD Calculations

To determine and calculate the MACD, we must subtract a 26 period Exponential Moving Average (EMA) from a 12 period EMA. Then, a 9 period EMA of the MACD is plotted, and this becomes the Signal Line for the indicator. The Signal Line is plotted over the MACD and this will be used as the trigger reading for trading signals (both buy signals and sell signals). These elements form the basis of the MACD construction, and it is important to have a strong understanding of these elements if you plan on using the indicator in your daily trading.

Three Common Approaches to the MACD

Now that we understand the basics of how the MACD is calculated, it is a good idea to look at some of the common ways that the MACD is viewed by traders so that we can get a sense of how exactly the indicator is used to identify trading opportunities. There are a few different ways the indicator can be interpreted, and the three of the most common methods proven to be the most effective for traders include Crossovers, Divergences, and in identifying Overbought / Oversold conditions

Since the indicator has become a major part of the technical trading community, it is a good idea to look at some of these approaches in greater depth. But before you can do this, it is essential you understand the basics. Failure to do this is what leads to a large number of losses for many traders that are just getting started.