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The Moving Average Convergence Divergence or MACD histogram is one of the most popular technical indicators used by traders. The MACD was created by Gerald Appel in the latter part of the 1970s to signal changes in the direction, strength and momentum of a stock price trend.
The MACD basically plots the difference between two different Exponential Moving Averages or EMAs. An EMA consists of a moving average which is weighted with each older data point decreasing in importance without ever reaching zero.
The MACD indicator is typically made up of three different lines. The first is the horizontal zero line, which shows when the difference between the fast moving average and the slower moving average converges. Next is the set of vertical difference or divergence lines that forms a histogram of the level of divergence between the two moving averages over time, and which oscillates above and below the zero line. The third is a trigger line, which is typically plotted over the MACD to give trading signals.
Many traders use 26-period and a 12-period EMAs for the MACD indicator and nine periods for the trigger line, which are the parameters originally recommended by Appel. Nevertheless, the lengths of the moving averages can be adjusted to better suit a particular currency pair or traded asset.
Trading MACD Signals Using Binary Options
Traders typically use the MACD’s signals when the market is clearly trending, without too much choppiness in trading conditions that might cause false signals. The primary signals for this indicator occur when:
(1) A crossover of the two component EMAs is observed,
(2) The MACD histogram crosses its trigger line,
(3) The indicator reads in extreme territory that suggests an oversold or overbought market, and
(4) A divergence of the MACD relative to price becomes evident.
A crossover of the MACD’s two EMAs shows up on the indicator when it crosses the zero line. If the indicator was reading in positive territory prior to the crossover, then a downward crossover is a bearish signal that might suggest establishing a long binary put position. Conversely, an upward crossover is a bullish signal that could indicate a long binary call position might be appropriate.
A binary option trader could also use MACD signals generated by the histogram crossing over its trigger line in a similar manner. An upward crossover of the trigger line would be bullish and indicate a binary call purchase, while a bearish downward crossover of the trigger line would suggest buying a binary put.
Swing traders typically follow trends until the market reaches extreme territory, which would be oversold in a downwards trend or overbought in an upwards trend. While the MACD indicator does not have fixed levels for such zones, like the Relative Strength Index for example, traders can instead observe where the MACD histogram is reading relative to its past extremes.
A MACD reading near former extreme high readings might be taken as a signal of an overbought market, which would indicate purchasing a binary put option to trade the anticipated correction lower. On the other hand, a low or oversold MACD reading would suggest a binary call option purchase.
Trading MACD Divergence Signals Using Binary Options
Divergence occurs when extremes in the level of the MACD indicator diverge from those observed in the exchange rate. The fact that the indicator shows divergence indicates that the market may be close to a reversal point, and this could be confirmed by an overbought or oversold condition existing in the market. Divergence is an especially useful MACD signal when the underlying asset’s price or currency pair’s exchange rate has been in a trend for some time.
Bullish divergence is seen when the MACD fails to make a lower low and instead only falls to a higher low point when the underlying asset makes a new low. When this type of divergence occurs as the underlying asset is making new lows, it can then be considered a fairly reliable signal indicating a bullish reversal may be forthcoming in the near term.
A binary option trader observing bullish divergence on the MACD could purchase an At-the-Money binary call option if they were mildly bullish or a greater amount of an Out-of-the-Money binary call option to increase their leverage if they wanted to take a more bullish position.
Bearish divergence occurs when the MACD fails to make a higher high in an uptrend and instead makes a lower high when the underlying asset makes a higher high. When this type of divergence occurs as the underlying asset is making new highs, it can then be considered a fairly reliable indication that a bearish reversal may be setting up.
A binary option trader observing bearish divergence on the MACD could purchase an At-the-Money binary put option if they were mildly bearish or a greater amount of an Out-of-the-Money binary put option to increase their leverage if they had a more bearish view.
Example of a Bullish MACD Trading Signal in EUR/USD
The daily candlestick chart below shows the MACD histogram in grey in the indicator box using EMAs of 12 and 26 days, and a nine day period for the red Trigger line, which is plotted over the MACD to generate trading signals. Binary option traders could watch such a chart for points where the MACD crosses over its red trigger line in extreme territory.
The EUR/USD chart below illustrates a classic example of such a crossover, where the MACD was at an exceptionally low point, and then crossed above its red trigger line to generate a bullish signal. This crossover in extreme low territory indicated that the market in EUR/USD was ripe for an upward correction, perhaps prompting an observant trader to buy an At-the-Money binary call option expiring in one or two weeks’ time.
The EUR/USD exchange rate then traded sharply higher, as anticipated by the bullish MACD signal. The trader could then either exercise their now In-the-Money binary call option at expiration or sell it back before expiration if they thought that the corrective upward move had probably exhausted itself.