When the market explodes out of a channel, either rising above resistance or dropping below support, use the momentum technique with the MACD. This is generally a position trade, lasting several days or even a month. While you’ll pay a small overnight renewal fee (with most brokers) to keep the trade active, these trades generally bring in enough pips to make holding the position well worth your while.
Moving Average Convergence/Divergence (MACD) is a popular indicator that works well in momentum markets. MACD (pronounced mac-d) plots three different exponential moving averages, and displays them as two lines of different colors that criss-cross atop the chart itself or within the window below it. One line is the MACD itself; the other is called the signal or trigger line.
The MACD also plots a histogram, which is a sort of bar chart in the window below the currency pair’s price chart. On the MACD histogram, there is a line that signals the zero point, called the centerline, and the bars of its chart rise and fall above and below that centerline like a wave. The histogram illustrates the difference between the MACD line and its signal line; when they cross each other, the histogram will read zero.
If your software platform wants you to set the configuration of the MACD, the most popular settings are 12 and 26 for the indicator itself and 9 for the signal line. Experiment to find what works best for you and your own trading style.
Like the RSI, MACD can indicate when a currency pair is overbought or oversold. There’s no specific number to indicate this, but when the lines of the histogram get really long, that’s a good hint that a reversal could be near.
Again like the RSI, MACD can indicate divergence. When the price reaches a new high or low but the MACD line doesn’t, that could mean the momentum is weakening. Again, a reversal could be near.
The technique
When the MACD crosses its signal line, that’s an entry signal in the direction the MACD line is going. If it falls below its signal line, look to see if a short trade is feasible; if it rises above it, go long. This signal is considered especially strong if, shortly after the crossover happens, the price of the currency pair breaks above resistance or below support; that could signal a big move.
Be aware that the MACD is a lagging indicator, so its signals won’t call the absolute highs and lows for you. That’s why it’s not helpful in a range-bound market: if you base your entry points only on the MACD, by the time the indicator catches up to the current price, the price may have risen or fallen so far within the channel that there’s no longer enough of a trade left to be profitable.
When using the MACD in a momentum market, where price has broken through support or resistance and is reaching new highs or lows, the MACD signals may start showing divergence, indicating the trend is weakening when perhaps it really isn’t. In that situation, watch the price chart itself, and compare what it is telling you to what the indicators show.
For example, let’s say the GBP/USD has broken out above resistance and is reaching new highs. The MACD signaled the break by crossing over its trigger line, but as the price continues to rise, the MACD doesn’t reach new highs, indicating divergence, and you wonder if the trend is weakening. Meanwhile, the price continues to rise.
Should you bail out? No. Watch the chart.
As the GBP/USD continues to rise, it will fluctuate in short - and intermediate term trends, going down a bit then rising again. This is called market jitters, or swing lows (if the currency pair was falling, they would be called swing highs). Don’t let it bother you; it’s perfectly normal.
Notice that each new swing low is higher than the one before. The market doesn’t swing down so much that the long-term trend changes; it just retraces itself for a while, then resumes its climb. It looks rather like someone dribbling a basketball up a hill, each dribble higher than the one before. (You do, of course, have your stop set far enough away that the swings don’t trigger it and kick you out of a profitable trade. Hopefully your broker offers a trailing stop, so it rises to follow as the price goes up, locking in your profits.)
Wait for that pattern to change. When a swing low goes lower than the previous one, that’s the bail-out point. Close your trade, then sit back and calculate your profits.