What Is MACD

13 October 2020

    Moving Average Convergence Divergence (MACD) is a technical analysis indicator proposed by Gerald Appel in his book “Technical Analysis Power Tools for Active Investors”. MACD is an indicator that shows the relationship between the values of two moving averages, a fast exponential moving average and a slow moving average. MACD comprises of three lines, MACD line, Signal line and the Histogram. The purpose of MACD is to monitor changes in the direction, strength, momentum and duration of a trend for an instrument. In other words MACD is a trend-following momentum indicator. The most common moving averages used for the calculation of the MACD are the 26-period Exponential Moving Average (EMA) and the 12-period Exponential Moving Average.

     

    How Is MACD Calculated

     

    As explained above, the MACD indicator plots three lines - MACD, Signal and the Histogram. The MACD line is the result of the subtraction of the long period exponential moving average from the short period exponential moving average. The Signal line is an exponential moving average of the MACD line and, at last, the Histogram is the difference between the Signal line and the MACD line. MACD is plotted on separate chart below the main window and looks as follows:

     

    How Is MACD Calculated

     

    To add a MACD indicator in Fondex cTrader, right-click on the chart and navigate to Indicators > Oscillators > MACD Crossover. After clicking on MACD Crossover, the below form will appear. 

     

    How to add a MACD indicator in Fondex cTrader

     

    In this form you select the MACD Source, the Long Cycle and Short cycle which represent the respective EMA periods, the Signal periods, the Shift, customize your line’s color thickness and type, set the overbought and oversold levels, and press OK. The MACD Crossover indicator will be added to the bottom of your screen.

     

    How To Use MACD in Trading

     

    MACD has a positive value when the short exponential moving average is above the long exponential moving average, and it is negative when the short exponential moving average is below the long exponential moving average. A positive reading of the MACD line is a clue that we are on a bullish price trend, and a negative reading of the  MACD line - that we are on a bearish one. When the MACD line is rising, this means that the divergence between the two exponential moving average indicators is increasing, meaning that the bullish trend is strengthening, and when the MACD line is falling - we have an indication that the bearish trend is having momentum. Based on these interpretations of the MACD line values, we present below some of the most popular MACD-based trading strategies.

     

    MACD-Signal Crossover

     

    A popular trading strategy using the MACD indicator is called MACD-Signal Crossover. The MACD-Signal Crossover strategy instructs to look for crossovers between the MACD line and the Signal line. When the MACD line crosses the Signal line from below, it means we have an accelerated buying activity. This is often considered as a momentum buildup and a bullish signal, since the price is expected to move upwards. On the other hand, when the MACD line crosses the Signal line from above, then sellers seem to come into play. Hence a bearish momentum is building up and we have a signal to sell, since the price is expected to fall further.

     

    Below we can see some examples of MACD crossovers taken from Fondex cTrader on a EUR/USD h1 chart. The MACD line is represented in blue and the Signal line - in red.

     

    MACD-Signal Crossover

     

    The yellow boxes highlight the crossovers between the MACD line and the Signal line. We can then observe the price movement after the crossovers. After the MACD line crossed the Signal line from above, the price dropped, but when the MACD line crossed the Signal line from below, the price followed an upwards trend. The price movement indicates that in this case the signals were valid.

     

    MACD Divergence

     

    Another popular trading strategy that employs the MACD indicator is the MACD divergence strategy. A divergence is a scenario where the indicator is moving to the opposite direction of the price. An MACD indicator divergence happens when the two following events occur:

     

    1. The price moves upwards, following a buying trend and forming higher highs, but the MACD line forms consecutive lower highs 
    2. The price moves downwards, following a selling trend and forming lower lows, but the MACD line moves upwards, forming higher lows. 

     

    An MACD divergence is an insight that the current price trend is fading out, making a reversal possible.

     

    The chart below shows a typical MACD divergence.

     

    MACD Divergence

     

    On the chart we can observe how the price is on a downward trend, forming new lower highs and lower lows as it progresses. But at the same time, the MACD line seems to have a different opinion about the markets, and forms consecutive higher highs and higher lows. This is a strong indication that the market is preparing for a reversal, something that we can observe happening after the end of the divergence, with both the price and the MACD line aligned eventually into an upwards trend.

     

    MACD Zero Cross

     

    A different way to trade the MACD indicator is to look for zero crosses, in other words, moments where the MACD line crosses above or below the zero line. Practically, a MACD zero cross occurs when the two exponential moving averages cross each other on the price chart. Zero crosses are used to identify the formation of strong trends. In contrast to MACD crossovers, which are more focused on detecting reversals, zero crosses try to identify the establishment of an already formed trend. A zero cross strategy is considered a more conservative way to trade the MACD indicator, as it signals entries after a trend has already started, but it is known to provide less false positives than the MACD Crossover strategy.

     

    Below we can see some examples of signals given by a Zero Cross reading of the MACD indicator

     

    MACD Zero Cross

     

    In the chart above, we highlight the areas where we can notice MACD zero crosses. When the MACD line crosses zero from below - we have a signal for a stronger bullish trend to follow, while a zero cross from above prepares traders for a potential sell-off.. 

     

    MACD Overbought/Oversold Zones

     

    MACD is most often used to detect forming trends and reversals. However, an unconventional use of the indicator is for identifying overbought and oversold situations. In contrast to other bounded oscillators, like the relative strength index, MACD does not have an upper and a lower boundary value, Hence, it is difficult to set fixed overbought and oversold zones. The way that an overbought/oversold state can be identified using MACD is by monitoring the divergence between the MACD line and the Signal line. The MACD is overbought when the MACD line is above the Signal line, and a relatively large distance is formed between the MACD line and the Signal line. When this happens, it is expected that the bullish move will be exhausted after the strong increase, and a bearish reversal might be on the way. The oversold MACD signal is opposite to the overbought signal. When the MACD line is below the Signal line and a relatively large distance is formed between the MACD line and the Signal line, then you are getting an oversold MACD signal. In this case we expect the price to exhaust in its decrease and to initiate a new bullish move.

     

    Below we can see some examples of oversold and overbought cases on a chart, as well as the respective reversals..

     

    MACD Overbought/Oversold Zones

     

    Limitations of the MACD

     

    The MACD Indicator, as any other technical indicator, always needs to be used in context. An out of context interpretation of the MACD patterns can generate a lot of false signals that could lead to substantial losses. Therefore, when using the MACD indicator, always consider the market fundamentals that currently move the market, and combine the signals with other confirmation signals, like trend indicators, support/resistance levels and the relevant price action taking place on the chart.

     


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#Article#Educational#indicator#MACD#Indicator