BY GARY L. TILKIN

A lthough many stock tradersbelieve short-termtrading is a new phe-nomenon, its beengoing on for years in the foreignexchange (Forex) market. Unfortu-n a t e l y, many short-term Fore xtraders (like stock traders) do notpay enough attention to thelonger-term picture provided bymonthly and weekly data.

One reason monthly and week-ly analysis is important is commontechnical studies such as the mov-ing average converg e n c e - d i v e r-gence (MACD) tend to givestronger signals when longer-termdata is used. Well show how touse the MACD indicator to estab-lish a top-down (long-term toshort-term) analysis approach.

F i g u re 1 (right), a monthly chartof the British pound with theMACD histogram (see Movingaverage converg e n c e - d i v e rg e n c e , page 2), shows how starting with along-term view will keep you on

the correct side of the market. In early1991, the first rally in the British pound tothe 2.000 level was confirmed by theMACD, as indicated by the upward -sloping line 1. However, the second testof the same level in August 1992 corre-sponded with a negative diverg e n c ebetween the price and the MACD, indi-cated by the downward-sloping line 2.( A d i v e rgence occurs when price movesin one direction and the indicator movesin the opposite direction.) Longer- t e r md i v e rgences such as this can alert the

trader to potential weakness in the mar-ket. Had you reacted to this sign, youwould have been ready when the free falls t a r t e d .

As with most technical indicators, themost reliable MACD signals occur whenthe monthly, weekly and daily analysesa re all in agreement. However, this is notalways the case; a lack of agre e m e n tbetween the time periods may cause sometraders to miss significant opportunities

Copyright 2001 Active Trader magazine.Reprinted with permission from the June 2001 issue of Active Trader magazine (www.activetradermag.com).

The MACD divergence identified by line 2 on this monthly chart warned that theBritish pound was ripe for a downturn.

FIGURE 1 BIG PICTURE

British pound, monthly

1 2

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

2 . 0 5 0 0

1 . 9 8 0 0

1 . 9 1 0 0

1 . 8 4 0 0

1 . 7 7 0 0

1 . 6 3 0 0

1 . 5 6 0 0

1 . 4 9 0 0

1 . 4 2 0 0

1 . 3 5 0 0

0 . 0 5 3 7

0 . 0 3 3 7

0 . 0 1 3 7

- 0 . 0 0 6 3

- 0 . 0 2 6 3

- 0 . 0 4 6 3

Source: Strategem Software and Bridge Data

MACD divergencesNo 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

short-term trades.

TRADING Strategies

or trade the wrong side of the market. To get a better feel for how to use

the MACD, lets first set a fewguidelines and then follow asequence of events in the Japaneseyen.

The trending character of thecurrency markets lends itself to atop-down approach where theshorter-term trades are confirmedby the longer-term trend.

Divergences in the monthlyMACD signal the major trend haschanged.

Divergences in the weeklyMACD histogram signal correctionswithin the major trend.

Divergences in the daily MACDhistogram also signal corre c t i o n swithin the major trend. However,trades against the long-term trendshould be treated carefully.

F i g u re 2 (right) shows a long-term chartof the Japanese yen together with amonthly MACD histogram. From A p r i l1990 to April 1995, the value of the yenrose 50 percent, when the exchange rated ropped from 160 to 80 yen per dollar.(For anyone not familiar with exchangerates, a simple way of looking at this isthat in April 1990 it took 160 yen to buyone dollar; a few years later, it took only80 yen.)

Today you can trade the Forex marketin $100,000 lot sizes, with leverage as highas 100 to 1, which means you can partici-pate in the market with only a $1,000 mar-gin re q u i rement. (This increases both thep rofit potential and risk of trading in thismarket.) When the yen doubled in valueto the dollar, it equaled a change in theexchange rate of 80 yen (160-80) or 8,000pips, which is the Forex term for thesmallest possible price increment. To cal-culate how much a one-pip move is worthin dollars, divide $1,000 with the curre n tnumber of yen to the dollar. At the begin-ning of the above move each one-pipchange was worth $6.25 (1,000/160); atthe end of the move it was worth $12.5(1,000/80); and on average over the entireperiod it was worth $8.3 (1,000/120).

During this appreciation of the yen, theMACD formed its first divergence in1993, shown by the upward sloping line 1.

This divergence continued to grow into1995 (line 2). Double divergences, espe-cially those formed over a two-year peri-od when viewed using monthly data, ares t rong signs a major turning point is ath a n d .

The dollar then rallied from 80 yen inearly 1995 to 145 yen in June 1998. Duringthis rally, the MACD formed an initiald i v e rgence in 1997, and a much stro n g e rone in 1998, as indicated by line 3. At thispoint, even the shortest-term Forex trad-

er should have been warned that a shiftin the overall bias, from being bullish thedollar to being bearish the dollar, waswarranted. The ensuing decline thatended in the latter part of 2000 took thedollar back to the 100 are a .

Consequently, during the early 1995to mid-1998 period, the monthly MACDtold you to emphasize the long side and,more often than not, buy dollars and sellyen. Between mid-1998 and late 2000,

continued on p. 3

Moving average convergence-divergence

The moving average convergence-divergence (MACD) indicator,designed by Gerald Appel, is created by taking the differencebetween two exponential moving averages (default values of 12 and26 days). An additional nine-day EMA is typically applied to the resultingoscillator to provide a signal line. Accordingly, the standard indicator issometimes referred to as the 12-26-9 MACD.

The MACD has a number of uses, including crossovers of the MACD and thesignal line. Essentially, a buy (sell) is issued when the signal line crossesabove (below) the MACD line.

The difference between the MACD line and the signal line is sometimesplotted as a histogram below the actual MACD. This is simply an alternateway of representing MACD-signal line crossovers: When the histogram cross-es above the median line, it represents the signal line crossing above theMACD line (a buy signal); the opposite is true when the histogram crossesbelow the median line. Also, divergences between the MACD and price cansignal trend exhaustion (see Figures 1-4).

ACTIVE TRADER June 2001 www.activetradermag.com 3

The longer-term divergences on the monthly Japanese yen chart provided advancenotice of the major switch from downtrend to uptrend in 1995.

FIGURE 2 MONTHLY DIVERGENCES

U.S. dollar/Japanese yen, monthly

1

3

2

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

1 6 2 . 0 0 0 0

1 5 3 . 0 0 0 0

1 4 4 . 0 0 0 0

1 3 5 . 0 0 0 0

1 2 6 . 0 0 0 0

1 1 7 . 0 0 0 0

1 0 8 . 0 0 0 0

9 9 . 0 0 0 0

9 0 . 0 0 0 0

8 1 . 0 0 0 0

7 2 . 0 0 0 0

3 . 1 1 8 7

2 . 1 1 8 7

1 . 1 1 8 7

0 . 1 1 8 7

- 0 . 8 8 1 3

- 1 . 8 8 1 3

- 2 . 8 8 1 3

Source: Strategem Software and Bridge Data

the monthly MACD favored the shortside, which would have meant sellingdollars and buying yen

Line 1 in Figure 3 (above) shows therewas no divergence formed by the weekly

MACD histogram during the yens initiala p p reciation in the early 1990s. However,the MACD is often misleading in stro n g-ly trending markets. To its credit, it didshow a strong burst of upside momen-tum on the dollars first rally in 1995.

During the subsequent appreciation ofthe dollar, the weekly MACD never

reached the initial high levels of1995. However, it did make marg i n-ally higher highs until August 1998,when the histogram formed aneight-week negative diverg e n c e(line 3). Looking back to Figure 2,you can see that the monthlyMACD histogram formed a secondmajor divergence at the same time.In keeping with the MACD guide-lines, there was strong evidence of asignificant turning point with boththe weekly and monthly MACDsignals working in tandem.

Now, lets look at the daily datain Figure 4 (bottom left). Note thatby early August 1998 the dailyMACD histogram was forming along-term divergence to the down-side, as indicated by line 1. Thisdivergence later was confirmed bya shorter-term divergence (line 2),which was given further weightwhen the MACD histogramdropped below the previous lows a sign of greater downside

momentum.This is where those traders who focus

solely on the daily and intraday datamost often interpret the MACD incor-rectly. A trader who has missed a majorrally often looks at the first daily diver-gence in the MACD histogram as a rea-

son to trade the short side. But ifthe daily divergences are notaccompanied by weekly diver-gences, as they were in this case(see Figure 3), the corrections indi-cated by the daily MACD are gen-erally short-lived. They can betraded by scalpers, but it is oftenbetter to set up new entries in thed i rection of the weekly andmonthly trend.

Because the MACD indicatorworks like an oscillator based on at rend-following indicator (themoving average) it lends itselfespecially well to catch currencytrends, both with and against thelonger-term underlying trend.

To make the most of this indica-tor, however, its important thatyou work with a top-downa p p roach, always making sureyou know what type of trendingmov