The MACD or the Moving Average Convergence Divergence indicator can spot momentum changes or trend strength, but it can also be used for signaling trades, and that's what will be discussed in this post.
The MACD crossover strategy is one of the simplest ways to use the indicator as a trend following system; it will help you get in on the trend, enables you to stay in it and reaps you big gains once you close your position.
But before you begin studying this strategy, please read the Disclaimer and Risk Warning at the bottom of this page. Also, do note that the results shared in this article don't guarantee this strategy's profitability. The testing performed only captures a narrow time horizon and on a few selected currency pairs. It's best if you conduct the necessary backtesting yourself to appreciate the strategy's performance fully.
Components of the MACD
Now, going back to the meat of the matter, the MACD strategy.
The first thing you must know is what comprises the MACD.
Three EMAs are needed to complete the MACD, with 26, 12, and a 9-day EMA as the standard configuration.
This article will not go into the details for constructing the MACD or the EMA. But if you want more information on calculating the MACD, read our Understanding The MACD Indicator article.
What will you need for this strategy?
This strategy is pretty straightforward.
You'll make use of only the MACD to signal the trades for you.
It will be the sole indicator of your chart, and the rest of the stuff to do is money management and trade monitoring.
The Signal: What to look for?
What you need to keep an eye on is the histogram of the MACD for a cross between the MACD line and the signal line.
If the MACD line crosses above the signal line, that's a bullish trade.
On the other hand, if the MACD line crosses below the signal line, that's a bearish trade.
However, a trade isn't prompted by the intersection of the two lines alone, as that'll most likely trigger a lot of false signals and multiple trades that may be difficult to manage.
So, as soon as the crossover occurs, the technique to be more selective is to look for three histogram bars ascending in height, and the same is true for a bearish signal.
If, for example, the middle bar is lower than the first one, no trades will be taken.
Suppose the third bar is lower than the second one, again, no trades.
Once the timeframe concludes with a histogram bar higher than the two preceding it, a trade will be placed.
Buy Trade: When the MACD line crosses above the signal supplemented by three histogram bars with each succeeding bar taller than the one before it, take a long trade.
Sell Trade: When the MACD line crosses below the signal line along with three histogram bars below the baseline, and each succeeding bar is taller than the one before it, take a short trade.
Pending Order or Market Execution
You have two options for placing your trades, but it may be better to place orders at a few points (or pips if you're trading Forex) above or below the market price.
For example, when you get a signal to buy a currency pair, you place a BUY STOP at 5 pips (or more) above the market price or the high of the most recent candlestick.
The reason for doing this is to make room for the market to move in the direction of your trade.
If you place a buy or sell order right away and it turns to the opposite side, you will incur more losing trades than you'd like, but if you place pending orders, you're most likely going to reduce the losing percentage of the strategy.
Managing the Trade
Once in the trade, you need to keep an eye on the exit, the stop, and the next entry.
Setting your stop-loss
You can set your stop-loss in two ways: a specific price level dictated by technicals or by price volatility.
But regardless if you allow the chart to direct the best place to assign your stops or preset the number of pips or points yourself, you need to be able to set your risk per trade properly.
Managing the stop-loss
Now, the majority of your time will be spent on managing your trade through moving your stop-loss proactively.
As your trade moves to the direction that favors your order, you have two choices: move the stop-loss to breakeven or keep it from where it sits.
Naturally, moving your stop to breakeven would result in lesser flexibility for your trade, i.e., you might get stopped out early, preventing a more significant loss, but it curtails any possibility of your trade to turn favorable.
And, the opposite applies if you leave the stop-loss order as it is.
Should you resort to an early close, you must see a sizeable floating profit first.
To get out of a losing trade when you let it take its course instead of adjusting your stop-loss is to wait for another crossover.
When this crossover happens before the market hits your stop, close the trade to conclude it with a loss much less than your actual risk.
The same intersection of the MACD line and the signal line is your exit strategy but in reverse.
For example, you had a buy order for your trade (MACD line crosses above the signal), your early exit would be when the MACD crosses below the signal line.
Trailing your stops
Again, when you see a good amount of profits with your trade, you can trail your stop-loss each time the market reaches a new high or low.
Alternatively, you can wait after three or four candlesticks print on the chart before you move your stop-loss closer to the market price.
Taking the Profit
And finally, similar to trailing stops and closing bad trades early, you can also use the crossover of the MACD and the signal line to take profits.
Since no take profit orders will be set using this strategy, this is what you'll use to lock in profits.
Proper money management rules should be implemented.
Opting out of the early close (stop-loss at breakeven) will put you in a position where you absorb all the risk when the market hits your stop.
It's important to note that you don't close profitable trades prematurely when this happens so that the percentage of risk doesn't overtake the reward rate.
Since this strategy works like fishing for the big catch, it may not present a high win rate.
In fact, from the backtesting done on the daily timeframe with this strategy, it only had a 40% win rate, but the profit gained was 16% of the initial deposit.
As you can see, this MACD crossover trading strategy works best to catch trends and ride through it until a signal from the MACD says it's about to reverse.
Backtest with a Backtesting Software
Now, remember, the strategy presented here is for informational purposes only, and you may do your own testing with a dependable backtesting software to verify the profitability of this system.
We suggest you read our review of ForexTester to learn more about how it can help you.