How to trade the MACD

The moving average convergence divergence (MACD) is an oscillator that combines two exponential moving averages (EMA) – the 26-period and the 12-period – to indicate the momentum of a bullish or bearish trend. MACD can be used to indicate opportunities to enter and exit positions.

It is one of the most popular technical indicators in trading and is appreciated by traders worldwide for its simplicity and flexibility.

Read on to learn more about the MACD and some of the MACD strategies used by traders.

MACD: An Overview

The concept behind the MACD is simple. It calculates the difference between a security’s 26-day and 12-day exponential moving averages (EMA). Each moving average uses the closing price of its period (26- and 12-day) to calculate its moving average value.

On the MACD chart, a nine-period EMA of the MACD itself is also plotted. This line is called the signal line. It acts as a trigger for buy and sell decisions when the MACD crosses it. The MACD is considered the faster line because the points plotted move more than the signal line, which is considered the slower line.

MACD Histogram

The MACD histogram is a visual representation of the difference between the MACD and its nine-day EMA—not highs and lows. The histogram is positive when the MACD is above its nine-day EMA and negative when the MACD is below its nine-day EMA. The point on the histogram where momentum is zero is the zero line.

If prices are changing rapidly, the histogram bars grow longer as the speed of price movement – its momentum – accelerates and shrink as price movement slows.

Trade Divergence

Divergence refers to a situation where factors move away from or are independent of others. With the MACD, this is a situation where price action and momentum do not act together.

For example, divergence may indicate a period where the price makes consecutive lower highs, but the MACD histogram shows a sequence of higher lows. In this case, the highs move lower, and price momentum slows, predicting a decline that eventually follows.

By averaging their short, the trader ends up earning a nice profit as the price makes a sustained reversal towards the final point of divergence.

Types of MACD Strategies

Histogram

The MACD histogram can be a useful tool for some traders. While we explained a bit above about how to read it, here’s how it works. It outlines the difference between the fast MACD line and the signal line. Traders can use the MACD histogram as a momentum indicator to jump ahead of changes in market sentiment.

There are three different elements involved in the histogram, which is mapped around a baseline:

The MACD line (produced by subtracting a long-term EMA from a shorter-term EMA) The signal line (produced by subtracting the two EMAs and creating a nine-day moving average) The histogram (produced by the MACD subtract line from the signal) line)

However, keep in mind that the MACD histogram has its flaws (see the “Disadvantages” section below). Many traders often use other tools and techniques to determine and make their moves based on market sentiment, such as the trading volume of a given security.

Crossover Strategy

A crossover occurs when the signal and MACD lines cross each other. The MACD generates a bullish signal when it moves above its own nine-day EMA and generates a sell signal (bearish) when it moves below its nine-day EMA.

Zero-Cross Strategy

When the MACD crosses the zero line from below to above, it is considered a bullish signal. Traders usually take long positions when this happens. If it crosses the zero line from top to bottom, it is considered by traders as a bearish signal. Traders then enter short positions to take advantage of falling prices and increasing downward momentum.

In both cases, the longer the histogram bars, the stronger the signal. When there is a strong signal, it is more likely – but not guaranteed – that the price will continue in the direction of the trend.

Cash flow index

The money flow index allows traders to use price and trading volume to identify and determine when assets are overbought or oversold in the market. This oscillator moves between 0 and 100 where readings below 20 are oversold and 80 are considered overbought.

However, one of the disadvantages of this strategy is that it tends to produce fewer signals. This is because the readings it produces are extreme due to the fact that they are focused on jumps in volume and prices.

Relative Strength Index (RVI)

The relative growth index (RVI) is a commonly used momentum indicator in technical analysis. It measures how strong a trend is by comparing the trading range of a certain security to its closing price. The comparison is made using a simple moving average (SMA) to smooth the results.

Traders generally believe that the value of the RVI increases as a bullish trend continues to gain momentum. This is because, in this case, an asset’s closing price tends to fall at the higher end of the range. The opening price, on the other hand, remains further down at the lower end of the range.

MACD With RSI and SMA

Traders can often use the MACD and Relative Strength Index (RSI) indicator strategy. This allows them to use both the RSI and the SMA to their advantage. But what are they?

The RSI allows traders to measure how strong a trend is, while determining different points of reversal along that trend line. It is charted along a baseline of 14 periods across two different levels: an oversold and an overbought. Where the levels are set depends entirely on the trader and their strategies. Some may choose conservative levels of 20 and 80. The SMA calculates the average range of prices by the number of time periods in that range, usually with closing prices. This indicator allows traders to determine whether they believe a trend will continue or reverse.

Combining these three strategies together enables traders to:

Project future price changes using the RSI See how strong a trend is and where it is headed using the MACDU use the SMA as a lagging trend following indicator

Disadvantages of MACD

Like any oscillator or indicator, the MACD has drawbacks and risks.

One of the main risks is that a reversal signal can be a false indicator. For example, the zero cross image above has a point where the MACD crosses from below and back again in one trading session. If a trader entered a long position when the MACD crossed from below, they would be left with a losing stock if prices continued to fall. MACD does not function well in sideways markets. If prices generally move to the side when they stay within a range between support and resistance. MACD tends to drift towards the zero line because there is no up or down trend – which is where the moving average works best. Additionally, the MACD zero crossing is a lagging indicator because the price is generally above the previous low before the MACD crosses the line from below. This can cause you to enter a long position later than you might have been able to.

Example of a MACD Trading Strategy

We will use our zero cross image for a MACD trading example. As the trade continues, you see that the MACD initially crossed the zero line from below, then crossed again from above. A trader can see the histogram bars moving down with the MACD, indicating a possible reversal and opportunity for a short trade.

When the line crossed from above, the trader could take a short position and take a profit when the prices started to climb again.

The zero cross strategy can be used again to take a long position when the MACD crosses the zero line from below. At the point circled in our image, prices have risen and momentum is up. The trader can take a long position at this point.

The Bottom Line

MACD is one of the most widely used oscillators because it has been proven to be a reliable method of identifying trend reversals and momentum. There are several strategies for trading MACD, including those described above. Try each one to find the one that works best for you and your trading plan.