You should be familiar with the technical indicator that you want to apply on your chart, and its purpose, as well as the rationale for the math behind it, must make sense to you.
The last thing you want to do is to have a chart congested with technical indicators that serve nothing but confound your analysis since you only have introductory knowledge about most of it.
Now, if you're considering the MACD to supplement your existing technical lineup, then you'll learn a lot from this article as it will guide you in understanding the MACD Indicator.
What is the MACD?
The Moving Average Convergence Divergence is a technical indicator for signaling momentum changes, spotting trading opportunities, determining trend strength, and following trends.
Its primary components are two Exponential Moving Averages, with a 26-day EMA and a 12-day EMA applied on closing prices as the common settings.
The 26-day EMA is then subtracted from the 12-day EMA and plotted as a line called the MACD line on the Histogram.
And, the third component is a 9-day exponential moving average of the MACD line itself and is plotted together with the MACD; it's called the signal line.
Moving Average Convergence Divergence Uses
The changes in the momentum are detected by the MACD line and the signal line; the farther apart they are from each other, the stronger the momentum is, and when they converge, it may indicate a slowdown, a pause, or a total shift in the direction of prices.
The screenshot of gold's chart above tells the following:
- 1The MACD line crossed below the signal indicating that bearish momentum could be underway. And, even though the Histogram graphed a significant distance between the MACD and the signal line, the price of gold didn't fall substantially lower.
- 2There's no discernible upward or downward momentum here, so that's why the MACD line and signal line intersected thrice within the period encapsulated by the rectangle outline.
- 3As the MACD line crossed above the signal line, the subsequent price action confirmed the bullish signal.
- 4After being far apart from one another for about two months, the MACD line and signal line intersected once again. Here the signal from the MACD showed a slowdown of bullish momentum.
- 5And, finally, the move of the MACD line above the signal line signified the continuation of gold's price ascent.
- 6The crisscrosses on the two lines here resemble the same occurrence described in number 2 with the big red candle igniting the breakaway of the MACD line from the signal line.
Spotting Trading Opportunities
With the same mechanics of diagnosing a change in momentum, finding trading opportunities follow a similar pattern. Some traders make use of the signal brought about by the diverging of the MACD line and signal line as an impetus for a trade.
Determining the strength of a trend
By applying trendlines on the graph of the MACD line and the signal line itself and contrasting it with the highs and lows made by the actual prices, you can determine whether the current trend will prevail or if there's an impending reversal.
Here's an article from Investopedia for you to learn how to spot trend reversals with the MACD.
Although there can be false signals from the crossing of the MACD line and the signal line, there can be correct ones that predicate a strong trend too. With the aid of the Histogram, you can tell whether there's an opportunity to get in on the trend or stay on the sidelines. More of this later.
What is the purpose of the MACD Histogram?
The Histogram is a graphic representation of the distance between the MACD line and the signal line. This makes it simpler to determine how far apart or how close the two lines are from each other.
Colored histograms are even more helpful, like the ones from TradingViews charting package.
When the MACD line is higher than the signal line, a green bar appears and a red one when it's the opposite.
There's also an additional detail of a lighter green or red bar when the previous bar was higher.
How to calculate the MACD?
Now, for this section, you'll learn how you can calculate the MACD yourself.
- The first step is to get the 12-day and 26-day EMA (if you don't know how to do this, read this article).
- Then, subtract the 26-day EMA from the 12-day EMA. So, for example, if the 12-day EMA for the GBP/AUD is 1.7654 and the 26-day is 1.7809, the difference is -0.0155.
- And, the last step is to get the 9-day EMA of the difference of the 12-day and 26-day EMA.
Constructing the MACD with Excel
While there are different ways traders make use of the MACD, especially in conjunction with other technical tools and price patterns, the two strategies highlighted here uses the MACD individually.
Before you start reading, please read the Disclaimer at the bottom of this page.
Trend following using the Histogram
The Histogram can prove to be useful for substantiating a trade entry as opposed to executing a trade immediately after a crossover.
The thing you have to look for in the Histogram to validate your entry are three consecutive bars after a crossover with each succeeding bar higher than the one before it. If there's an absence of the three bars, the trade is invalidated.
- The converging of the signal line and MACD line took place and lingered there from August 16 to 21. When the two lines broke apart from each other on the 22nd and the Histogram showed three bars that are ascending in height, it confirmed a buy trade that would've bagged in about 600+ pips with this strategy.
- The crossover here with the three bars from the Histogram confirmed another entry (this time a short position) with a 700+ pip move until the next crossover occurred.
As you can see, there are a few other times that the crossover happened in this chart, but there's an absence of the three bars. Between 1 and 2, a crossover occurred without the three bars, and the GBP/AUD didn't move much lower.
There's also some choppiness heading to December and a crossover on the 5th, but, once more, no three (ascending) bars. Therefore, zero trades were signaled even though the price of the GBP/AUD ticked upwards.
The exit for this strategy is either through a trailing stop or closing the trade upon the next crossover.
- The MACD is an indicator that's comprised of two indicators, the two Exponential Moving Averages.
- The MACD can be used to identify momentum changes, trading opportunities, trends, and market strength.
- The MACD strategy discussed here involves the use of the Histogram to confirm a trade entry.
TRY IT YOURSELF!
Now, the best way to learn this strategy is to start using it yourself, but it's best if you test it out on a demo account or a backtesting software before with actual money.