How to use the moving average convergence divergence (MACD) indicator
The moving average convergence divergence indicator helps a trader to estimate the trend direction, potential reversals, and the momentum.
The moving average convergence divergence or MACD is a useful technical analysis tool because it is able to determine the trend as well as the momentum. Apply this indicator when you develop a trend trading strategy.
The MACD indicator is an oscillator type indicator that plots the difference of two trend-following indicators. It is a so-called lagging indicator, which means it can confirm long-term trends but doesn’t predict them.
What is the MACD?
The MACD indicator is composed of three parts:
- MACD line – the difference between the fast moving average and the slow-moving average
- Signal line - signals changes in the price momentum
- Histogram – shows the difference between the MACD line and the signal line.
MACD calculation includes two exponential moving averages, the fast period (or shorter period) and the slow period (or longer period), and the periods included are 12 and 26, respectively. Accordingly, the MACD formula is:
MACD=12-Period EMA − 26-Period EMA
Aside from the MACD line, you can also see how the signal line and the histogram are calculated.
Signal line = 9-day EMA of MACD line
MACD histogram = MACD line – signal line
On your chart, the MACD indicator would be set up at the bottom and you will be able to see two lines, the MACD line and the signal line. Another element which is commonly plotted on your MACD setup is a histogram, which enables you to see the difference between the MACD and the signal line. The signal line represents the 9-period exponential moving average of the MACD.
As a momentum oscillator indicator, the lines oscillate around the baseline without any defined oscillating boundaries. Lack of oscillating range makes the MACD indicator inadequate if you want to identify potential overbought or oversold signals. In general, the default setting for the MACD is 12, 26 and 9. Usually trading platforms offer the possibility for these values to be adjusted in accordance with your strategy. An example of how a MACD indicator can appear on your chart is presented with the next graphic.
Using the currency.com trading platform, your MACD default setup would be as shown in the graph. The blue line represents the MACD line while the signal line is the red line. You can also see the histogram where values oscillate above or below zero.
How to read the MACD indicator
MACD reading entails that you look at the movement and the position of the lines in relation to each other and in relation to the baseline. Accordingly, when defining a trading strategy or entry and exit position, you can interpret the signals from the moving average convergence divergence indicator in reference to:
MACD and baseline crossover (zero-line crossover) – you can determine potential upward or downward movement when you analyse the movement and the position of the MACD line in relation to the baseline set at zero.
- When the MACD moves above the baseline, it is labelled as a bullish movement
- When MACD moves below the baseline, it signals potential bearish movement.
MACD signal line crossovers – the crossover signals with MACD are similar to the signals which we can get when using a moving average. You want to find a point where the MACD line crosses above or below the signal line.
- When the MACD line crosses above the signal line, then it is a bullish signal.
- When the MACD line crosses below the signal line, then a bearish signal is determined.
Don't forget that the strength of the movement can be determined in accordance with the location of the cross above or below the baseline. The further the crossover is from the baseline, the stronger the expected signal is.
MACD divergences – can be identified in a similar manner as it is the case with some other indicators. The divergence generally refers to a period in which the price action and the indicator lines don’t move in the same direction. You can identify this situation by looking at the highs and the lows of the price and indicator values.
Histogram signals – you can get an insight into the potential trend strength and potential reversal by looking at the histogram values.
Converging and diverging lines – signals can arise from the degree of convergence or divergence between the lines when you want to see the strength of the momentum.
If you identify ranging market conditions, then you should know that using the MACD indicator can result in whipsaw positions because the indicator can change value swiftly and move above or below the signal line or the baseline.
You can examine the momentum strength using the MACD indicator:
- A stronger trend is determined when the two lines are moving further apart.
- A weak trend is determined when the two lines converge toward each other, which is also an indication for a possible reversal.
This difference between the lines is shown with the histogram and you can determine the trend strength based on how tall the histogram is above or below the zero-line; the taller it is, the stronger the trend will be. Noteworthy mentioning is that a reversal in the trend can be expected when the histogram moves over the zero-line.
Although the MACD indicator is a versatile indicator, you should try to combine it with other indicators. By doing so, you will be able to confirm profitable signals and reject potential signals, which may cause a loss. Since it falls in the trend indicators category and has features of a momentum indicator, you can combine MACD with indicators such as a stochastic oscillator, relative strength index, as well as volume indicators.
Advantages of MACD trading
- It’s a simple trading indicator that can provide adequate signals
- The MACD provides signals for the trend strength
- The ability to determine a trend reversal is one of the main advantages of the MACD indicator compared to some of the other technical analysis indicators because trades may identify potential entry and exit points;
- It provides updated information compared to moving average indicators.
Disadvantages of MACD trading
- It is not advisable to use the MACD indicator if you are a long-term trader because the indicator is considered to be a short-term indicator, for the reason that the longest period it includes is the 26-day exponential moving average.
- You need to find the best MACD setup for different assets or for different markets
- As a lagging indicator, when it signals potential trade, you have usually missed some of the profits, because you will enter the position later.
- The MACD divergence can provide early signals, which can lead to some negative positions before entering a profitable one.
An example of a MACD signal line crossover is shown in the graphic below.
You can see that there are two bullish and two bearish signals on the graph representing the daily price chart for Facebook. The bearish signals are marked with red circles and they are the points when the MACD line (blue line) crosses below the signal line (red line). The points marked with white circles show a bullish alert when the MACD line crosses above the signal line.
FURTHER READING: What Is the relative strength index?
FURTHER READING: How to read and use moving average indicators