All you need to know about the MACD indicator

The Moving Average Convergence Divergence (MACD) is a technical analysis indicator commonly used in stocks, bonds, commodities, and other popular financial assets. It is a trend-following momentum indicator that shows the relationship between two moving averages of an asset’s price over a certain period.

In this detailed guide, learn the MACD indicator, how it works, and how traders can effectively use the MACD trading strategy in their trading.

What is a MACD indicator?

The MACD indicator was developed in the late 1970s by Gerald Appel, a technical analyst. The aim was to identify changes in the strength, direction, momentum, and duration of a trend in a stock’s price.

It was revealed to the public in Appel’s 1979 book, “Technical Analysis: Power Tools for Active Investors.” The book helped popularise the use of the MACD among technical analysts and traders. In the 1980s and 1990s, the MACD became one of the most popular technical indicators traders and financial analysts used to study charts and identify trading opportunities. It remains today a prevalent indicator for analysing trends and momentum in stocks, indexes, commodities, and forex pairs.

This article may pique your interest: How To Trade CFDs On Commodities

How the MACD indicator works

The key to understanding the MACD indicator is knowing its main components. The indicator consists of three core components:

Two moving averages were calculated

The foundation of the MACD indicator is two separate moving average lines that are calculated and plotted on the price chart. They include:

MACD line: As mentioned, the MACD line is a 12-period exponential moving average. This shorter-term EMA reacts more quickly to recent price changes. The 12-period EMA is plotted alongside the price action to show short-term momentum.

Signal line: The signal line is slower at a 26-period exponential moving average. Because it tracks a more extended historical period, it reacts more slowly to price fluctuations. This EMA line lags behind recent price activity.

These two EMAs are calculated based on the price action and plotted together on the chart. The two moving averages converge, diverge, and crossover, creating trading signals.

Histogram

In addition to the two EMAs, the MACD indicator also consists of an MACD histogram. The MACD histogram visually represents the difference between the two EMAs, showing how they converge or diverge over time. The histogram oscillates above and below a centre zero line, with positive values indicating that the 12-period EMA is higher than the 26-period EMA and negative values showing the opposite. The MACD histogram is a valuable tool for traders to identify potential trend changes and momentum in the market.

For further information, read this article: What Is A Trading Indicator And How It Helps You As A Trader

Benefits and drawbacks of using MACD

Using the MACD indicator has several advantages that can support your trading strategy. Here is how it will benefit you.

• Identifies momentum shifts - The main benefit of a MACD trading strategy is identifying subtle changes in momentum earlier than would be apparent in just the price action alone. This helps traders enter favourable trades sooner and exit losing trades faster.
• Simple trading signals - Between MACD crossovers, divergence signals and histogram analysis, the indicator produces clear, easy-to-interpret trading signals validated by generations of traders.
• Versatile across time frames & markets - The MACD produces effective trading signals whether you apply it to stocks, forex pairs, or any other tradable security. It also works on multiple time frames, from 1-minute charts to weekly.
• Easy to combine with other analyses - Since the MACD indicator is straightforward with highly visible signals, it integrates seamlessly with trend analysis, support/resistance, chart patterns, and other technical indicators.

However, there are also some disadvantages when using this indicator:

• Lagging nature - While often earlier than just price action alone, all lagging indicators face the issue of reacting rather than predicting. The lag time in calculating and averaging the moving averages underlying the MACD mean signals emerges late.
• Signal inaccuracy - No indicator is perfect or accurate 100% of the time. MACD signals, like all technical signals, can be subject to false alerts and irrational price action. Traders should incorporate other confirmation measures rather than rely solely on MACD triggers.
• Subject to whipsaws - When markets trade sideways, swinging between a range, the MACD lines often crossover repeatedly, resulting in whipsaw action where stops are hit, but no actual trend emerges. Too much reliance on MACD in choppy or ranging markets can cause premature trade stops.
• Repainting issue - The mechanics behind calculating moving averages means historical MACD signals can change based on the most recent data, which impacts previous values. This re-calculation causes the issue of repainting older signals that the trader may not initially see.

The MACD trading strategy is invaluable, but traders should know it isn’t perfect. Using the MACD in combination with other indicator confirmations will provide the most trading edge with the fewest false signals. Integrating MACD with a structured, planned, and tested trading strategy is vital.

5 tips for using the MACD trading strategy

While the MACD indicator offers helpful trading signals, it performs best when combined with other analyses. Here are some tips for using the MACD effectively:

1. Use with trend analysis: Apply the MACD in the direction of the prevailing trend. For example, if an uptrend is confirmed, focus on bullish MACD crossover buy signals. Be careful trading countertrend MACD signals. These signals can also be false signals that lead to losses. Therefore, it is important to consider the market context and other technical indicators before making a trading decision based on the MACD.
2. Combine with chart patterns: MACD divergence and crossover signals will be more reliable when confirmed by classic chart patterns like double tops, head and shoulders patterns, triangles, flags, and so on.
3. Use multiple time frames: Apply MACD analysis to multiple time frames. For example, watch for MACD divergences on larger timeframes (daily, weekly) to signal major trend changes ahead. Then, use MACD crossovers to time entries on smaller timeframes (5-min, 15-min).
4. Consider the market context: The overall market environment provides a critical context for interpreting MACD signals. For example, if the broader market is in a confirmed downtrend and bearish sentiment dominates, bullish MACD crossover buy signals should be viewed more sceptically. Going against a bear market with lots of downward momentum is difficult and often unwise. Factoring in the market backdrop provides perspective on the validity of any indicator signal.
5. Use with other indicators: The MACD can be made more effective when confirmed by other technical analysis indicators. For example, suppose the MACD triggers a buy signal. In that case, the RSI is moving into oversold territory, and Stochastics are bottoming, which provides three indicator confirmations and higher odds that the signal will play out profitably. Or if the MACD sell signals while the 50-day moving average crosses below the 200-day MA, the odds shift bearish.

Looking for agreement between the MACD and indicators like oscillators, moving averages, candlestick signals, volume surges, Bollinger Bands expansion, etc., serves to validate the MACD signals. The divergence between indicators often precedes trend changes. Using the MACD and other technical analyses creates more robust and profitable trading.

Integrating the MACD into your broader trading approach takes practice but can significantly improve your market timing and ability to identify high-probability trade entries and exits objectively.

To bring this to a close

The moving average convergence divergence (MACD) is a broadly used indicator in technical analysis based on the differences between two moving averages. It gauges momentum and is constructed with a MACD line, signal line and a histogram, which interact to create high-probability trading signals.

The MACD indicator has withstood the test of time to become one of the most widely utilised indicators in the trader’s toolbox. With proper risk management, confirmation measures, and combining it within a structured trading plan, the MACD can provide a strategic market timing advantage to pull the trigger on trades more precisely.

Utilise the MACD indicator when trading at markets.com

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When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”