How to Trade Using Moving Average Convergence Divergence (MACD)

MACD Definition

The Moving Average Convergence Divergence (MACD) indicator is used by investors in technical analysis to identify new market trends, whether they be bullish or bearish, and their momentum. A MACD chart is comprised of three elements:

  • A line representing a faster exponential moving average (MACD)
  • A line representing a slower exponential moving average (Signal Line)
  • A chart (Histogram) that plots the difference between the two moving averages

How The MACD Indicator Works

MACD

In the MACD chart above, the blue line is the MACD, the red line is the Signal Line and the green chart is the Histogram. It is important to point out that the MACD and Signal Line are not moving averages of the asset price level as is commonly believed. Rather, they are moving averages of the difference between two moving averages. Additionally, the Histogram, as mentioned above, is the difference between the MACD and Signal Line, with the height of the bars representing the momentum of the trend. The taller the bars appear, the stronger a trend is. Conversely, when the bars get shorter, the trend is weakening or coming to an end.

How to Read a MACD Chart

Investors that want to begin trading with MACD as part of their technical analysis should ensure they understand how to read a MACD chart correctly, and what to look for. When assessing the information provided by this indicator, there are two points of interest to look out for:

  • MACD Convergence
  • MACD Divergence

MACD Convergence is when the two exponential moving averages on the MACD chart come together, or cross over each other. This MACD crossover can indicate the end of a previous trend, and the beginning of a new one. When the MACD crosses above the Signal Line, this indicates the appearance of a bullish market trend, acting as a buy signal to investors. In comparison, when the faster moving average crosses below the slower moving average, this acts as a sell signal as a bearish trend can be expected.

MACD Divergence is when the two lines on a MACD chart move away from each other. This action indicates the momentum, or strength, of a market trend, and the longer the lines remain diverged, the longer the trend will last.

Trading with MACD

MACD

Having understood how to read a MACD chart, let’s take a look at an example. In the chart above, the MACD Line (blue) crosses above the Signal Line (red) at point (1). This indicates an impeding bullish trend, acting as a buy signal to traders, which is confirmed by the asset price level moving upwards at point (a). The two lines diverge from that point, indicating the momentum of the trend, until they converge again at point (2), signalling the trend’s end. At point (2), the MACD crosses below the Signal Line, indicating the beginning of a bearish trend and functioning as the trigger for a sell signal. This is once again confirmed by the asset price level, which begins a downward movement from there, as can be seen at point (b). You may have also observed that, when this MACD crossover occurs, the Histogram disappears. The reason for this is that, at points where the moving averages cross, the difference between them is zero, which is what the Histogram reflects.

The MACD indicator is a powerful tool and is very useful for predicting short-term market trends that investors can take advantage of. However, and although the convergence of the two moving averages can indicate the beginning of a new trend, it is recommended that traders wait for the lines to start to diverge before opening a position. The reason for this is to ensure confirmation of the trend and avoid any potential losses from entering the market too early.

MACD Settings

When applying the MACD indicator to a chart, investors usually have three parameters to consider:

The period used to calculate the faster moving average
The default for this is usually set to 12, representing the previous 12 bars of the MACD Line
The period used to calculate the slower moving average
The default for this is usually set to 26, representing the previous 26 bars of the Signal Line
The number of bars used to calculate the difference between the moving averages
The default for this is usually set to 9, representing the previous 9 bars of the difference between the two

The parameters for the MACD indicator are often represented in the following format: (12, 26, 9).

Using these values as an example, the MACD Line represents the moving average of the difference between the 12 and 26-period moving averages. The Signal Line represents the average of the MACD Line’s previous 9 periods. Finally, the Histogram simply takes these two moving averages, and plots the difference between the two.

Although these are the most widely used, the best settings for the MACD indicator will depend on your trading strategy and objectives. As an example, the best settings for daily chart analysis will differ to those for hourly chart analysis. You can experiment with various values to find out which parameters are most suitable for your style of trading.

MACD in Real Trading Conditions

Having learned the basics about what the MACD indicator is, how it works, and how to read a MACD chart, let’s see how it can be used in real trading conditions. The chart below shows the performance of the EUR/USD currency pair in the Forex market between March and June 2016. As in previous examples, the MACD Line is indicated in blue, the Signal Line in red, and the Histogram in green.

MACD

The currency pair has been charted at a daily time-frame, and the default settings have been used for the MACD indicator (12, 26, 9). As we can see in the area highlighted above, the MACD Line converges below the Signal Line, indicating an impending bearish trend. After the lines cross, they start to diverge, confirming the beginning of the downwards movement, and acting as the trigger for a sell signal. This interpretation is mirrored in the asset price level, which experiences a fairly significant drop from the moment the lines converge, up until the next time this happens. Investors that had been employing sound technical analysis during this period, and noticed the developing trend, could have earned a decent profit by placing a sell order on EUR/USD at the point of convergence, or just after.

MACD

Returning to the same chart, but focusing on a different period, we can see that the MACD Line moves above the Signal Line. This indicates a bullish trend for the currency pair, something that is confirmed when two lines begin to diverge, which triggers a buy signal. The interpretation provided by the MACD indicator is once more mirrored by the asset price level, which begins to rise from the point of convergence. Traders that had placed a buy order on EUR/USD based on this data would have once again made a tidy profit.

In both the examples, we see the Histogram disappearing at the points of convergence between the faster and slower moving averages, as the difference between the two becomes zero. The size of the bars in the Histogram can also be seen growing when the two moving averages are further apart, indicating the strength of the current market trend.

Conclusion

The Moving Average Convergence Divergence indicator is a simple yet effective technical analysis tool that investors can use to identify bullish and bearish trends. As we have seen in the examples above, it is a fairly accurate indicator that provides actionable data for traders conducting chart analysis. As with any technical indicator, the settings required and the overall practicality of MACD will depend on each individual investor and their objectives. For example, those that focus on day trading in the Forex market will require different settings to those interested in trading Shares on a long-term basis. However, overreliance on this, or any other indicator for that matter, is not recommended, no matter how accurate the data provided is. Efficient technical analysis should always be combined with a thorough understanding of the financial markets, a well-formulated trading strategy and sound risk management, to ensure an investor can get the most out of their trading.

Did you know?

Currency trading and exchange are no new practices. In fact, money-changing people can be traced back to the Biblical times. Using city-stalls, they would help others change money and take a commission or charge a fee for their services.

Word of the day
"Basis Point (BP)" - A measure unit for interest rates which equals 0.01% and shows the percentage change in a financial instrument.
Pro Tip

Trades usually have more chances of being successful during high market activity.

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