What if you could choose the most important thing in trading?
As we said in previous analyses, the most important thing to do when investing money is to work on your trading strategy. Your capacity to stick to your trading plan will make the difference between success and failure.
Indicators are often used by traders to decide when to enter and exit the market. However, choosing indicators is never easy, as you need to really understand them and know how to interpret them.
Let's find out a key indicator:
One of the most popular mathematical indicators is the MACD indicator, which stands for Moving Average Convergence Divergence. This article will help you understand this indicator in depth, as well as how to improve your overall analysis skills.
What Is The MACD Indicator?
The MACD indicator was developed by Gerald Appel more than 35 years ago- it consists of 2 lines and 1 histogram.
The indicator is usually at the bottom of your chart, as you can see in the image below. Its name comes from the fact that it compares 2 moving averages and displays when they are converging or diverging.
A trading strategy based on the MACD indicator involves using buying and selling signals, based on a potential price increase or decrease being spotted.
Initially, Gerald Appel developed this indicator to highlight when momentum and prices are accelerating together, as well as when prices and momentum aren’t moving in sync.
Let’s look at it in detail:
The indicator is therefore used to measure momentum comparing 2 moving averages. As we can see in the above chart, there are 3 elements that make up the MACD. The blue line is called the MACD Line, while the orange line is called the Signal Line. The purple bars represent the MACD histogram. If you use this indicator on your trading platform you will see that the default values are 12, 26, and 9, but you can change them depending on your trading style.
Let’s now have a look at these 3 components:
1. The MACD Line
This line is one of the most important components of this indicator. This is the fast moving average. It displays the difference between 2 exponential moving averages: a 12-period EMA and a 26-period EMA.
Moving average (MA) is a trend tracking tool, which displays the average price over a given period. There are different types of MA. The EMA gives more importance to the current prices. Therefore, this type of moving average will more closely follow the price action than others, such as the Simple Moving Average (SMA). The EMA is more accurate because it is more reactive to price changes and new information available.
2. The Signal Line
This line is the slower line of the MACD. It’s a 9-period EMA of the MACD line.
3. The MACD Histogram
The histogram is an oscillator evolving around a reading of zero. It measures the trajectory of the MACD and will help you anticipate crossovers. The bars simply display the difference between the fast and the slow-moving averages.
Here’s how it goes:
As you can see on the 1stchart, each time both lines cross over, the MACD histogram disappears (see black arrows). This is because the histogram is the difference between the 2 lines. When they cross, the difference equals zero, so the histogram doesn’t display any bars. This is usually when a price movement is about to happen, as the histogram gets bigger when the lines separate.
- MACD line = 12-period EMA – 26-period EMAv
- Signal Line = 9-period EMA of the MACD Line
- MACD Histogram = MACD Line – Signal Line
The 3 Types Of Signals That The MACD Indicator Provides
1. MACD Crossovers
Crossover buying and selling signals are the most used type of signals traders use with the MACD. It happens when the 2 lines cross. It displays the moment where the momentum accelerates.
There are 2 types of crossovers: bullish and bearish.
Bearish MACD Crossovers occur when the MACD line crosses below the Signal Line – see the red circles. This signals that the price of the underlying asset is likely to decrease.
2. MACD Divergences
Another type of signal used with the MACD is called divergence. A divergence happens when prices are moving in one direction, but the indicator is moving in another one.
So how to identify them?
Bullish MACD Divergences happen when prices form lower bottoms, but the MACD forms higher bottoms. This signals that the price of the underlying asset is likely to reverse and increase.
Bearish MACD Divergences happen when prices form higher tops, while the MACD forms decreasing tops. This signals that the price of the underlying asset is likely to reverse and decrease.
Let’s look at another example:
we can see how important it is to use the MACD with Technical Analysis to validate signals. Basic technical analysis techniques, such as supports, resistances, trend lines, and channels are easy ways to confirm trading signals. Let’s have a look at the 2nd divergence.
How To Confirm A Divergence?
The EUR/USD is going upward forming new highs. However, MACD tops are lower. This bearish MACD divergence is confirmed by the price reversal. The currency pair trades above the major resistance for only 3 days. After that, it went back down, which also corresponds to a bearish MACD crossover.
Let’s zoom in:
If you are used to trading with candlesticks, you can easily recognize the reversal pattern in the red circle. It’s a shooting star. This is a bearish reversal pattern that indicates that the bullish pressure is losing momentum.
The buyers drove prices higher, but the sellers took control during the day and pushed prices down. The selling pressure was so strong that prices ended up the day at their lowest level.
This is an indication that traders should be cautious. The next candle is a bearish spinning top. The following candle is still bearish, as it has a long red candle with almost no shadow: a bearish marubozu. Sometimes, all you need to do is spot the marubozu. A marubozu is usually an indication of a strong buying or selling signal. In our example, as the body is red, it’s a strong bearish signal, especially as it happens on a major resistance level. As you can see, Candlestick analysis combined with Technical Analysis will help you to confirm trading signals coming from the MACD.
3. Overbought/Oversold MACD
It’s not a widely used feature of the MACD, but it can also give an indication of whether an asset is overbought/oversold. The MACD doesn’t have a dedicated area where it spots both situations. You can, however, see it by looking at the distance between the 2 main lines of the indicator.
Here’s the secret:
To spot overbought/oversold situations, traders should be looking for important rises/falls in prices that do not match the trend. If prices increase or decrease too quickly, there is only a small likelihood that they can keep the pace and remain at those levels. Therefore, they are more likely to reverse.
By looking at the MACD, you can spot these moments when the shorter moving average is diverging from the longer one. This is actually telling traders that prices of the asset have moved too far away from historical averages. Thus, there is a high chance that prices will be “forced” to go back to normal trading prices.
MACD Indicator – Things To Remember
The MACD indicator stands for Moving Average Convergence Divergence and was developed by Gerald Appel. This indicator is a momentum oscillator that will be more relevant in non-trending markets.
The MACD is a delayed and lagging indicator, as it is composed of moving averages. This indicator is very useful to avoid being against the trend. There are different ways you can get buying/selling signals from this indicator. You can mainly use MACD crossovers and MACD convergences/divergences.
When there is a new trend, the fast line will react 1stand can cross the slower one. Once this “crossover” has happened, the strength of the movement can be seen by the space between the lines. When the fast line starts to move further away from the slower one, you can see that a new trend has started.
To confirm trading signals, you can also use basic Chartism techniques that will help you determine better entry/exit points. Make no mistake, entry and exit points are an essential part of your trading plan. You must work on them as much as you should work on your risk and money management.
Remember to always use take-profit and stop-loss orders when trading, as it will protect your trading capital. Looking at previous important psychological levels on a chart will help you determine them. You can then use previous support and resistance levels. Do not forget to use a risk/reward ratio of at least 1:2. This means that you are targeting to earn twice the amount you are willing to risk.
The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions .