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.
When the two MAs cross, the MACD line crosses below 0 as well. As 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.
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.
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 the 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.