There are several chart types, chart patterns, and technical indicators that security analysts use to get an edge when trading financial instruments. To be profitable in trading, investors must be comfortable with utilizing and interpreting a large set of price data for the security that they intend to trade. This is where various Technical Indicators come in handy. In essence, Technical Indicators are mathematical tools that analyze numerous data elements (such as – price, volume, change momentum) on a security’s price chart, and provide traders with easy to interpret signals on existing market conditions. One of the most popular indicators for measuring a security’s short and intermediate-term price trends is the MACD.
MACD is an abbreviation for Moving Average Convergence Divergence. It is a popular momentum indicator that leverages historical price data for predicting the direction and the momentum of future price movements. Technical traders commonly use this indicator to measure divergence on the price chart of the security and to determine the strength of a price trend.
While its name sounds a little bit scary, MACD is actually a fairly simple indicator to read and to interpret. It consists of several components that are closely related and, when considered in conjunction, can help traders make an educated guess on the direction that a security price may take in the short term.
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How to Read MACD?
MACD is a straightforward indicator to read for traders who are familiar with line and bar graphs. There are three series in the indicator, two of which are traditional line graphs and the third one is a bar graph, commonly referred to as the histogram.
To accurately read signals from the MACD (Moving Average Convergence Divergence) Indicator, there are three sub-topics that you must to understand. These are –
- Construction of MACD Indicator
- MACD Indicator Calculations
- Interpreting MACD Signals
Now, without further ado, let us dive deep into all three of these sections so that you can start trading using the MACD signals in no time.
Construction of MACD Indicator
MACD comprises three time-series of historical price data that interact with one another: the fundamental MACD line, the MACD signal line, and the divergence between the two, often known as the histogram.
The following descriptors can help traders identify which time-series they are looking at:
- MACD line – This is a line graph that will often be defined by frequent bumps or sharp changes in direction. It will typically be colored black or blue.
- MACD signal line – This is also a line graph. It will follow the same general pattern and direction of the MACD line but will be much smoother and less volatile. It is usually red but can be any different color from the main MACD line.
- Divergence (histogram) – This will be easily recognizable as the only bar graph in the indicator, with the height of the bars in the histogram changing based on the level of divergence between the MACD line and the MACD signal line.
MACD Indicator Calculations
MACD is calculated by using the historical moving averages of a security price, generally the price at closing. Moving averages give traders an idea of the general trend in a security’s price over a given period. Usually, when trading on a daily timeframe, the short and intermediate time frames used in calculating MACD are the 9-day exponential moving average (EMA), 12-day EMA, and 26-day EMA.
Without getting into too much of the advanced math behind EMAs, it is a type of moving average that places greater weight on more recent data points. For example, when analyzing the price patterns of a stock such as Amazon, its price one year ago is of little significance compared to the price in recent days.
EMAs are useful for traders because they provide continuously updated data on the price trend of a security. Fortunately, there is plenty of software available that can instantly calculate EMAs over a given time and use this information to create the MACD indicator. Therefore, as a trader, all you really need is to have a basic understanding of how the MACD is created.
The following breakdown explains exactly how each time series of the MACD indicator (sometimes called the oscillator) are calculated:
- MACD line – This is the 12-day EMA minus the 26-day EMA. It will give a glimpse into the short and intermediate trend of a security’s price action, giving you hints as to whether the security is trending up or down.
- MACD signal line – This is the 9-day EMA of the main MACD line. It is a smoothed-out, less bumpy version of the MACD line, as the EMA of the MACD line itself creates a more normalized pattern.
- Histogram – The histogram is created by calculating the difference between the MACD line and the MACD signal line. When the difference is positive (positive divergence), there will be a bar extending up from the crossover line (point of intersection between red and black line). When the difference is negative, the bar will extend down.
While 9, 12, and 26 days are the typical time lengths used for creating the MACD indicator (for reasons dating back to the old six-day work week), it is essential to note that the trader can update these settings in any way necessary for his/her analysis. However, when software is set to “standard” MACD settings, these will be the periods used for indicator calculations.
Additionally, if you are trading on a different time frame, indicator settings would adjust accordingly. For example, if you are reading on an hourly time frame instead of daily, under its standard settings, MACD will use 9, 12, and 26 hour EMAs for all calculations.
Interpreting MACD Signals
In the simplest terms, the MACD is used to generate a “buy” or “sell” signal for traders. Depending on your trading strategy, you can either use these signals in isolation or just as a mechanism to confirm trading signals from other analysis methods.
- When the main MACD line crosses over the signal line, this usually indicates a “buy” signal for the trader.
- When the main MACD line crosses below the signal line, this typically appears as a “sell” signal for the trader.
- The histogram then becomes useful in indicating the strength of a signal. When there is a long, positive bar, this means a strong buy signal, whereas a long, negative bar represents a strong sell signal. When the bars on the histogram are short or nonexistent (indicating convergence of the two lines), then the trader may want to hold until a stronger signal arises.
Using this type of interpretation of the MACD indicator is commonly referred to as “signal-line crossover”.
- When the MACD line crosses over the signal line, this is known as a “bullish crossover”.
- Contrarily, when the MACD line crosses below the signal line, this is known as a “bearish crossover”.
If this is confusing to you, just remember that in trading jargon, “bullish” refers to optimism that the price of a stock, currency, market, or any other security that you are trading will rise, whereas “bearish” refers to skepticism and fear that the price will drop. Therefore, for a signal-line crossover, bullish means that the black line is above the red line, while bearish means the opposite.
In addition to signal-line crossover, there are a handful of other concepts that you should be aware of when interpreting the MACD indicator. These are –
- Zero crossover – This interpretation looks strictly at the main MACD line. When the MACD line crosses zero on the horizontal axis, it is known as a zero crossover. It is useful in showing bullish or bearish trends in the price of a security, but it does not send as strong of a buy or sell signal as a signal-line crossover.
- Divergence – This is visually represented by the histogram in the MACD indicator. Large divergence becomes recognizable when the price of a security hits an extreme, but the MACD histogram does not agree. For example, bullish divergence would occur when a price hits a low point for the given period, but the MACD has it valued higher, indicating a strong buy.
- False signals – This occurs when the price of a security does not follow what is anticipated from the signal-line crossover. To combat this, you may place a filter that requires three days of bullish signals before placing a buy, or three days of bearish signals before placing a sell. Additionally, you should also combine trading signals from MACD with other complementary analysis methods to improve the reliability of your trades.
- Timing – MACD is only as valuable as the context to which it is applied. An investor may look at the weekly trends in MACD before applying it to daily trends to avoid making trades that contradict the general movement of a security.
How Reliable is MACD in Trading?
In general, MACD is a reliable indicator for making trade decisions. While there are no guarantees when dealing with financial markets, and any tool or indicator will never be able to perfectly “guess” the future direction of a security’s price, the fact that the MACD has remained a favorite technical analysis tool among traders since the early 1970s speaks for its efficacy.
The reasons behind MACD being a reliable indicator for both novice and professional investors can be summarized as follows:
- It accurately and efficiently summarizes one of the oldest ideas in trading: to capitalize on divergence. Simply put, when traders feel like the future price of a security is higher or lower than what the market currently values it at, a trade should be made, and the MACD indicator succinctly captures this divergence in an easy to understand visual representation.
- By using EMAs over given periods in its calculations, MACD is better able to identify trends for traders. This approach has been statistically proven to be more accurate in predicting the momentum of a security than many other popular approaches.
However, as mentioned, no trading tool or indicator is perfect, and MACD does have some limitations. The following are some of the issues that traders can run into when relying too heavily on the MACD:
- Divergence does not always indicate a reversal in a security’s price. This goes back to the idea of false signals when trading using MACD. In this respect, MACD is better used for reading momentum than an overall change in trend.
- The MACD is a very reliable indicator for getting confirmation signals. But, it is difficult to make trading decisions based on stand alone output from this indicator. Hence, it is almost always necessary to use it in combination with other analysis tools.
- Trade decisions should not be made exclusively based on various tools and indicators used in technical analysis. Old fashioned data, such as security fundamentals, should always be a primary consideration.
- Although the use of EMAs keeps the price trends of a security regularly updated, MACD is still a lagging indicator, meaning that it is based on historical data and can only be used for extrapolation with inexact accuracy for predicting future trends.
- Sharp, one-time changes in a security’s price, followed by more normal movement, can cause extreme divergence in the MACD, which may be an inaccurate indicator of a forthcoming reversal.
- As MACD is a reliable measure of momentum in trends, it will more accurately gauge large trade volumes and not large price changes.
Now, after looking at all of these pros and cons with regards to this indicator’s reliability, it is crucial to consider some ways in which the reliability of signals produced by the MACD Indicator can be further improved. Therefore, in the next section we will briefly discuss a few effective and popular methods to improve the reliability of MACD Indicator in trading.
Improving Reliability of MACD Indicator in Trading
While MACD is a very useful tool in predicting the momentum of a security’s price, it can sometimes be misleading when looked at in isolation. Therefore, it is prudent for you as an investor to combine MACD readings with signals from other technical indicators or analysis methods to make wise trading decisions.
Listed below are several common indicators and tools that you can combine with MACD to improve the reliability of trading decisions made using this indicator:
- RSI – RSI, Relative Strength Index, is another popular momentum indicator that relies on recent price changes to indicate overbought or oversold situations for a security. When the trends in RSI are in agreement with those of MACD, investors can feel confident that the time is right to make a trade. When they disagree, the trader may want to wait for more data before moving forward with an identified trade.
- Candlestick Patterns – Candlesticks form patterns within a price chart based on numerous data points (such as – open, high, low, and close) across a number of different consecutive trading session combinations. These patterns can be bucketed as – Reversal Candlestick Patterns, Continuation Candlestick Patterns and Indecision Candlestick Patterns, and can help predict future performance of a security. If the MACD readings coincide with a prediction made from interpreting a candlestick pattern, then it may be time to enter a trade.
- Harmonic Patterns – Harmonic Patterns are fibonacci ratio based chart patterns that commonly appear on the price chart of a security. These patterns provide traders with a rational method to identify potential reversal points on the price chart and are considered to be very reliable in most trading situations. By combining the trading signals from Harmonic Patterns with the divergence readings from MACD, you can significantly improve the success probability of your trades as it will allow you to predict reversals more accurately.
- Support and Resistance – These are commonly used “floors” and “ceilings” for discussing a security’s price and are often areas on the price chart where a reversal may occur. If the MACD is signaling substantial divergence at a support or resistance point, it may be a strong indication that a reversal in price trend is about to occur.
- Moving averages – When analyzing the MACD, it is always a good idea to compare it against a larger moving average, such as a simple 50-day or a 200-day moving average plot. It may be imprudent to trust the MACD if it disagrees strongly with the larger moving average plot.
- Price – Even though this is as simple as it gets, look at the price of a security and see if it passes the eye test before entering a trade. Generally speaking, round numbers in security prices are known to act as psychological support and resistance levels. If the MACD divergence indicators support a reversal that is feasible with the security trading at a given price, it is probably time to enter a trade.
How to Trade Using MACD Indicator?
Similar to any tool and indicator in technical analysis, MACD should always be employed along with other complementary tools and indicators to identify and take profitable trades. To that effect, there are several different trading strategies in which you can leverage signals generated by the MACD Indicator to make profitable trades.
Listed below are three trading strategies in which MACD signals are know to incorporate really well:
- Breakout Trading Strategy
- Reversal Trading Strategy
- Scalping Trading Strategy
But, before discussing these trading strategies in necessary detail, let us first touch upon several trading jargons that will be used in describing them.
When discussing the various trading strategies, in investor jargon, it is common to hear the terms “long trade” or “short trade”, that are sometimes simply referred to as “long” or “short.”
- Long refers to a buying position or a situation in which a trader wants to hold onto a security for a “long” time because he or she believes that it will increase in price over time.
- Short refers to the opposite, or a selling position in which traders want to get rid of their securities in “short” order before they lose any more value.
Additionally, please note that in the following sections, each of the above mentioned trading strategies will be covered from the context of a bullish scenario. Hence, we will primarily discuss how you can make a long trade leveraging MACD to execute various trading strategies.
However, the same trading principles apply for bearish scenarios and “short” trades, only using the reverse logic.
Trading Strategy 1: Breakout Trading Strategy
The Breakout Trading Strategy is focussed around identifying price points at which a security’s price is likely to break its existing trading range and enter a high momentum, newly-formed price trend.
In this strategy, when bullish on a security, you would look for long trade opportunities once the price of the security is at or breaks above an established area of resistance. Similarly, you would look for a sell or a short-sell opportunity when the price is around an established area of support.
Breakout Trading is potentially a very profitable strategy. This is because the trades that you enter with this strategy can often lead to a period of high volatility in which the price of a security will move heavily in the direction of the breakout trend. Hence, there is opportunity for you to bag massive gains in relatively a very short duration of time.
When using MACD as an indicator to help with entering trades under the Breakout Trading Strategy, you will want to keep the following concepts in mind:
- Determining Trade Entry – When the price point of a security is set to close above a certain resistance level, the trader should immediately look at his or her MACD readings. If there is strong positive divergence, indicating that this breakout has resulted in the price forming a “low” high and that there are more “higher” highs likely to follow, then you should adopt a bullish position for the security and enter into a long trade.
- Determining Stop Loss Target – As mentioned, MACD can be susceptible to false signals. If the divergence indicates bullish momentum, but the price of the security goes back to the previous resistance level, then this security is not a true breakout candidate and must be sold to mitigate any losses. Hence, with such breakout trades, you would place your stop loss a few points below the resistance line on the break of which your bullish trade entry was triggered.
- Determining Take Profit Target – The take profit point determination can vary from trader to trader, depending on the level of risk he or she is willing to incur. However, the take profit strategy is fairly straightforward when relying on signals from the MACD Indicator. Once the MACD and signal line start to converge, it is time to sell and take the profits from the breakout trade.
Trading Strategy 2: Reversal Trading Strategy
The Reversal Trading Strategy is focussed around identifying the price points at which the price of a security is likely to reverse, and start a new trend that is counter in direction to its existing trend.
In this strategy, when bullish on a security, you would take a long position despite the overarching negative trend on the security’s price chart, in the anticipation of a trend reversal. Similarly, in the case of a bearish bias, you would short or short-sell a security despite its positive trend under this strategy. In essence, when trading with the Reversal Strategy, the investor believes that the price trend of the security is about to change direction.
The MACD is popular for its reliability as a confirmation indicator when employing the Reversal Strategy, as areas of divergence between the security’s actual price and the MACD indicator theoretically indicates a potential change in price trend.
However, while the MACD can be effective in identifying reversal trade opportunities, it should be used in combination with another momentum indicator, such as the RSI. This will help further boost the accuracy of the signals produced by MACD Indicator even further and ensure that the security is due for a reversal, despite the overarching price point. By leveraging signals from such complementary tools to further confirm your trade entries, you can avoid trading a false MACD signal in the face of extreme divergence.
Finally, when using the MACD Indicator to identify and take reversal trades, you will want to keep the following points in mind:
- Determining Trade Entry – This is disagreed on by some investors, many of whom feel that the best point for entry is when extreme positive or negative divergence occurs in the MACD. However, to avoid a false signal, you should wait for three consecutive sessions of divergence before entering a reversal trade. This will minimize the risk of you entering a trade too early and incurring losses as a consequence.
- Determining Stop Loss Target – The key to successfully employing a Reversal Strategy is being able to distinguish between a reversal and a pullback. A pullback is a short-term counter within an overarching trend that does not signal an actual reversal. Therefore, you should set your stop loss not more than 2% away from the price point at which you entered the trade when trading conservatively. For aggressive trading, signals from MACD are not sufficient to help determine your stop loss levels, and you will need to rely on alternative trading methods in technical analysis for this purpose.
- Determining Take Profit Target – Using the MACD, it is best to set your take profit point when you see a signal crossover. This is a likely indication that the momentum built up from the reversal is dying, so to play safe you may take profits here. Traders with a higher risk appetite may however wait for a strong divergence to appear in the opposite direction. This will enable them to close their position for profit just before a new reversal is likely to occur.
Trading Strategy 3: Scalping Strategy
Scalping is a trading strategy in which the trader tries to take advantage of small, short-term price changes. When trading with this strategy, you will attempt to make as many modest gains as possible and try to mitigate any losses that could wipe out any of the progress made.
Because it is a lagging indicator, it can be argued that MACD may not be the indicator of choice for scalpers, who will be required to make a high volume of trades, often on the same day. However, given the fact that the vast majority of technical indicators and tools are lagging, it should definitely not be dismissed for Scalping.
The following guidelines should be adhered to when using MACD with a Scalping Strategy:
- Determining Trade Entry – This is definitely a time when MACD aficionados need to be looking for a trend as opposed to a reversal. If there is a definite pattern of divergence over several days or trading sessions, the time may not be right to attempt a scalping trade in the direction of prevalent trend. Instead, you should only attempt to scalp trade when the price movement and the MACD Indicator are in complete agreement with each other.
- Determining Stop Loss Target – This is arguably the most critical factor for successfully employing a scalping strategy. Simply put, scalpers cannot afford to take significant losses. Therefore, traders using a scalping strategy should have a strict stop loss target of .5% below the purchase price, with anything more than that considered potentially catastrophic.
- Determining Take Profit Target – Similar to the stop loss target, the take profit target should be at .5% above the buy price. The thought process is that trends identified in MACD will allow the investor to make many more profitable trades than unprofitable ones, so getting greedy and waiting for big profits is too risky for this strategy.
Advantages and Limitations of Trading MACD
Trading MACD has long been a favorite technical analysis tool for investors and traders at varying levels of experience alike.
However, given the volatility of trading securities, no single analysis tool or indicator is perfect. MACD is no exception to this and consequently there are some definite advantages and disadvantages of relying on MACD for making trade decisions.
For high success probability trading, it is important that you are aware of these pros and cons associated with MACD, and have them accounted for in your overall trading plan. Therefore, in the following sections, let us discuss some of these key advantages and limitations associated with using MACD in trading.
Advantages of Trading MACD
Listed below are some prominent advantages of using MACD in trading:
- MACD signals are very easy to analyze and interpret for investors at all levels. For most part, you will need just a little more than basic understanding of reading line and bar graphs to implement MACD readings into your trading strategy.
- The use of EMAs gives traders continual updates on the most current prices of securities.
- MACD Signals helps identify trends and momentum in a security’s price direction. This can help investors make informed trade decisions relative to the given price point.
- Extreme divergence can allow investors to spot opportunities to buy or sell ahead of a price reversal.
- MACD has a long history of relevance among traders, dating back to the early 1970s.
Limitations of Trading MACD
Listed below are some important weaknesses of MACD, that you must account for in your trading plan:
- MACD tends to indicate false signals based on an incorrect interpretation of divergence patterns. Therefore, you must be cautious and careful in reading divergence.
- MACD readings are only relevant if the investor understands the time frame under which he or she is analyzing the security.
- This indicator is best used in combination with other tools and indicators in technical analysis. MACD is a great confirmation tool, but not very dependable as a standalone indicator.
- MACD is not the best tool to use for intraday trading, as the lagging nature of the indicator has limited ability to provide up-to-the-minute information.
- MACD signals can be thrown off by extreme, one-time price changes and it is thus better to use it for identifying trends over several days or trading sessions.
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Conclusion
Moving Average Convergence Divergence, more commonly known as MACD, is a popular indicator that traders use for spotting momentum trends on a security’s price chart. By properly interpreting signal-line crossovers and divergence, investors can successfully enter into “buy” or “sell” trades to capitalize on forthcoming trends in the market.
While popular and reliable when used and analyzed correctly, MACD does not come without drawbacks, as false signals can cause investors to incorrectly predict and/or miss out on price reversals. As such, MACD is best employed as a confirmation tool in combination with other complementary tools in technical analysis when trading various securities.
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