Effective Leading Indicator for FOREX
The foreign currency exchange market, Forex, allows traders to potentially profit from changes in exchange rates. It is a risky but potentially lucrative environment where large amounts of money can be made or lost in seconds. Traders seek advance knowledge of exchange rate movement. An effective leading indicator for Forex should ideally help a trader predict a turn-around in exchange rates. The "moving average convergence-divergence tool," or MACD, is one such indicator.
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Purpose
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The Forex market is strongly chart driven. Traders usually rely on price charts of exchange rates when making their trading decisions. A technical indicator is a tool that you apply to a price chart to better analyze the price action. Indicators take many different forms, but the MACD appears below the price chart as its own sub-graph. This simple indicator can effectively lead actual price action with predictive patterns.
MACD
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The MACD is a simple formula charted in the indicator's own graph. It takes the values of two moving averages and finds the difference between them. This result plots as its own line. Moving averages are inherently lagging indicators as they average together the prices that have already occurred in the market. However the MACD studies two averages of different durations to see how momentum changes in real time. The patterns that result from these momentum changes can be powerfully predictive and actually lead Forex price performance.
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Divergence
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"Divergence" occurs when Forex prices move in one direction but an indicator's analysis of those same prices instead moves in a different direction. Studying divergence is one of the main techniques in using the MACD. The best method for identifying divergence is to compare the direction of consecutive highs or lows in Forex prices with the same highs or lows in the MACD. If Forex prices make a new low that declines further than the prior low, but the MACD's corresponding low is actually higher than its own previous low, this is a form of divergence. In this common example, momentum is actually rising even as prices continue to fall. An aggressive trader might buy into this declining market with the expectation of a sudden turnaround. Often, the MACD's divergence signal accurately precedes the turnaround in Forex price action.
Warning
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Forex prices can diverge from the MACD indefinitely before the turnaround actually occurs. Or the MACD can diverge without a turnaround occurring at all. These two scenarios are common in strongly trending markets. While the MACD divergence is an effective leading indicator, it is not foolproof, and traders must recognize that it will not work 100 percent of the time.
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