Using the MACD to Spot Over-Bought and Over-Sold Conditions

Using the MACD to Spot Over-Bought and Over-Sold Conditions

One of the most effective MACD techniques is seen when traders are looking to identify over-bought and over-sold conditions in the forex markets.  In these cases, traders will be looking for prices to show a dramatic rise or a dramatic fall that does not match historical tendencies.  If prices rise too high, too quickly, there is a relatively small likelihood that prices can sustain themselves at those elevated levels.  Similarly, if prices fall too far, too quickly, there is a small chance that prices can sustain themselves at those historically inexpensive levels (without buyers coming in to capitalize on the opportunity).

So how to we spot these occasions?  And how, exactly, do we define an over-bought or over-sold condition?  When looking at the MACD indicator, we define these extreme conditions as any instance where the shorter-term moving average is seen pulling away from (or diverging from) the longer-term moving average.  What this is telling traders is that a currency has strayed too far from its historical averages and there is a strong chance that prices will be forced to return back to normal trading levels.

Zero Line

Another factor to consider in these cases is the zero line, which is a central aspect of the MACD indicator that serves as a foundation for directional price forecasting. When prices move below (or back above) the zero line, the MACD indicator is telling us that the shorter-term moving average is making changes in position in relation to the longer-term average.

“In cases where the MACD is higher than the zero line,” said Haris Constantinou, markets analyst at TeleTrade, “we can see that the shorter-term average has risen higher than the longer-term average.”  This is a key signal for forex traders because it suggests that the currency pair is producing positive momentum and that prices are likely to continue rallying in the future.

In bearish scenarios, the opposite characteristics will be seen.  In these instances, you will find that the MACD is crossing below the zero line, and we will be able to see that the shorter-term average has fallen below the longer-term average.  This is a key signal for forex traders because it suggests that the currency pair is producing negative momentum and that prices are likely to continue declining in the future.

A final point to note in these cases is that when looking at the zero line on the MACD layout, there will be many situations where the zero line can serve to act as something similar to support and resistance in the MACD indicator.  The indicator reading will generally have a difficult time pushing through the zero line because this signals that the market momentum is changing and this is never an easy thing for market participants to accept.  The reason for this is that many positions will have to be closed (and possibly reversed) and this can take some time before the process is complete and market momentum is actually able to see a real shift.