Ways to use MACD

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The MACD indicator – How To Use The MACD Correctly

The MACD indicator – How To Use The MACD Correctly

The MACD is a popular momentum and trend-following indicator that is based on the information of moving averages and, thus, ideal to act as an additional momentum tool and momentum filter for your trading. In this article, we will explain what the MACD indicator does, how it helps you analyze price and how to use it in your own trading.

First, let’s take a look at the individual components of the MACD indicator:

MACD Line: The MACD line is the heart of the indicator and by default it’s the difference between the 12-period EMA and the 26-period EMA. This means that the MACD line is basically a complete moving average crossover system by itself.

Signal Line: The Signal line is the 9-period EMA of MACD Line

MACD Histogram: MACD Line – Signal Line

In this article, we focus on the MACD and the signal line in particular. The histogram is derived from the other two components of the MACD and, thus, don’t add as much explanatory value to overall MACD trading.

The basics of the MACD indicator

As I said, the MACD is based on moving averages ad this means that it’s ideal for analyzing momentum, finding trend-following entries and staying in trends until momentum is dying off.

There are 2 MACD signals in particular that we will explore in this article and explain step by step how to use the MACD to find trades:

1) The MACD Line cross 0

Besides the MAXD lines, I also plotted the two moving averages on the charts and it becomes obvious immediately how the MACD works.

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When the two MAs cross, the MACD line crosses below 0 as well. As В I said above, the MACD is thus its own moving average crossover system in just one line.

As we know from our moving averages article, a cross of 2 MAs shows a change in momentum and it can often foreshadow the creation of a new trend. So, whenever the MACD Line crosses 0, it shows that momentum is changing and potentially a new trend is just being created.

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1) The Signal Line

When you see the two MACD indicator lines move away from each other, it means that momentum is increasing and the trend is getting stronger. When the two lines are coming closer to each other, it shows that price is losing strength.

However, the MACD is an oscillator and during very strong trends, it won’t give very accurate information. Thus, when you are in a strong trend, don’t get confused by too many crossings of the MACD lines.

TIP: As long as the MACD lines are above 0 and price is above the 12 and 26 EMAs, the trend is still going on.

Trend-following entry

During ranges, the two lines from your MACD are very close together and they hover around 0; this means that there is no momentum and no strength.

At point #1, the price also formed a narrow range and when the price breaks out, the two indicator lines pull away from the 0 line and also separate each other. Then, during a trend, the moving averages can act as support and resistance and stay you in trends as the phase #2 and #4 show – the price never broke the moving averages.

During a consolidation like in point #3, the MACD contracts sharply as well and traders wait for the breakout of the wedge to signal a new trend.

The divergence at#5 is a signal we will explore below and it predicted the reversal. During the downtrend #6, the price then again stayed below the moving averages while the MACD lines stay below 0.

MACD divergences as early entries

MACD divergences are another great way to analyze price and find early trend-following trades.

You can see in the screenshot below how theВ price was moving higher very slowly over a long period of time. At the same time, the MACD moved lower showing that there was no buying strength behind the slow grind. Then, suddenly, price broke below the two moving averages with stronger which happened while the MACD lines crossed below 0 and also separated further. This can be the signal of a new strong downtrend.

Overall, as with most indicators, you probably don’t need them when you can read momentum information directly from your chart. But indicators can be great tools for building confluence and also to create more objectivity in your trading.

HOWEVER, never let anyone tell you that indicators don’t work. They do! It just comes down to how you use them.

How to Use the MACD Indicator

MACD is an acronym for Moving Average Convergence Divergence.

This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish.

With an MACD chart, you will usually see three numbers that are used for its settings.

  • The first is the number of periods that is used to calculate the faster-moving average.
  • The second is the number of periods that is used in the slower moving average.
  • And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
  • The 12 represents the previous 12 bars of the faster moving average.
  • The 26 represents the previous 26 bars of the slower moving average.
  • The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the green lines in the chart above).

There is a common misconception when it comes to the lines of the MACD.

The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.

In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages.

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average.

This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average.

If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.

This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average.

As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.

And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!

Ok, so now you know what MACD does. Now we’ll show you what MACD can do for YOU.

How to Trade Using MACD

Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.

When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend.

This is because the difference between the lines at the time of the cross is 0.

As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.

Let’s take a look at an example.

In EUR/USD’s 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend would eventually reverse.

There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it’s just an average of historical prices.

Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, MACD is still one of the most favored tools by many traders.

MACD: What it says about stocks now

As of mid-March, this short-term indicator suggests stocks are relatively expensive.

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Key takeaways

  • MACD is a technical indicator that can generate buy-and-sell signals.
  • It is particularly useful in trending markets.
  • Currently, MACD suggests stocks may be expensive on a short-term basis.

A decade beyond the nadir of the financial crisis, investors commemorated the 10-year birthday for the S&P 500’s bull market in mid-March. This, after having their worst week of 2020 thus far.

International markets have also had somewhat of a sour tone lately, as the European Central Bank recently cut its growth forecast for the region and China announced some weaker-than-anticipated export data. Yet multiple global markets are still up double digits in 2020 on a total return basis, including the US—as measured by the S&P 500.

If stocks are still in a strong uptrend, active investors with short-term time frames may want to consider using MACD, in addition to other fundamental and technical methods, to evaluate the market. Currently, MACD as applied to the S&P 500 is registering an overbought signal, suggesting stocks may be expensive on a short-term basis.

How MACD works

The Moving Average Convergence-Divergence indicator, commonly known as MACD, is a technical indicator consisting of 2 lines—the MACD line and the signal line—as well as a bar chart. It is used to generate buy-and-sell signals, and to determine whether an investment or index may be overbought (i.e., potentially expensive) or oversold (i.e., potentially cheap).

MACD can be approximated by subtracting the value of a longer exponential moving average (EMA) from a shorter one. The shorter EMA is constantly converging toward, and diverging away from, the longer EMA. This causes MACD to oscillate around the zero level.* A signal line is created with an EMA of the MACD line. See the chart below for a sense of what MACD looks like.

MACD indicator applied to the S&P 500

Using MACD

MACD is a momentum oscillator that is generally best employed in trending markets—where prices are trending in a particular direction. If you are considering MACD, you should make a determination as to the trend of the market.

Short-term buy-and-sell signals are generated by the MACD line and the signal line. These 2 lines fluctuate around the zero line, which is found on the y axis on the right side of the chart. The zero line is also significant because it can act as support and resistance.

Oscillators like MACD are generally most valuable when their value reaches extremes of its boundaries. However, MACD can theoretically rise or fall indefinitely. If you were to apply relative extremes to the MACD indicator (i.e., the MACD and signal lines are far away from the zero line), the signals would be as follows: when the MACD line is well below the zero line in extremely negative territory, it can suggest an investment may be oversold (i.e., a buy signal). Alternatively, when MACD is well above the zero line in extremely positive territory, it can suggest an investment may be overbought (i.e., a sell signal). Currently, the MACD line and signal line are both above the zero line, suggesting stocks are expensive. However, they are not at an extreme overbought reading.

In regards to the zero line, a sell signal is given when the signal line or the MACD line crosses below the zero line, and a buy signal is given when they cross above the zero line. The MACD line and signal line crossed above the zero line (a buy signal) in January and stocks rallied for several weeks after that signal.

The difference line, represented in the chart above by the blue bars, is typically presented as a bar chart around the zero line. This bar chart represents the difference between the MACD line and the signal line, and is designed to help depict when a crossover may take place. Recall that a crossover generates buy and sell signals. A narrowing of the difference line (i.e., when the bars decrease) illustrates the potential for a crossover.

These signal line crossovers, as opposed to zero line crossovers, are typically the more frequent action many traders look for when using MACD. A buy signal is generated when the MACD line crosses above the signal line, and a sell signal is generated when the MACD line crosses below the signal line. As the chart above illustrates, a sell crossover signal occurred in late February. The next possible signal line crossover would be a buy sign (the MACD line crossing above the signal line).

Confirming the trend

Timing is everything

Choosing the time frame is very important as it can impact the look of the MACD chart, and potentially the interpretation and timing of signals. Experience using the MACD can help you determine the appropriate window, and it may be necessary to use multiple time frames to confirm your analysis.

One technique that technical analysts may use to confirm the direction of the trend is to determine whether the MACD indicator is making higher highs or lower lows in conjunction with the price. Many traders wait for a “trigger,” or some sort of confirmation of the divergence. Both the S&P 500 and MACD lines had been making higher highs until the recent market weakness and rounding top pattern for the MACD lines.

Of course, you should never use a technical indicator in isolation. Instead, it can be one of many tools you use to evaluate the market or an investment opportunity. With the market potentially back in a trading range, indicators like MACD may be particularly helpful for short-term investors.

Next steps to consider

Match ideas with potential investments using our Stock Screener.

Learn what you need to know before trading the market.

Learn about more technical indicators and how they can help you trade.

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