The Moving Average Convergence Divergence (MACD) is an indicator based on trend following, which traders use to establish the correlation between two moving averages.
It is a technical indicator used to point out moving averages that highlight new trends in any direction. Note that traders are keen on finding bullish and bearish trends to identify trading opportunities.
MACD is obtained through the reduction of the 12-period EMA and the 26-period. From the subtraction, the Moving Average Convergence Divergence line is derived. A nine-day EMA of the signal line is marked above the MACD line, indicating sell and buy signals.
What Does the MACD Technical Indicator Tool Measure?
Traders use MACD to measure trends’ strength and momentum using the zero line and the MACD line as points of reference.
Essentially, anytime the MACD line goes on top of the zero line, it indicates an upward trend. The reverse is also true; if the MACD line cuts across below the zero line, it signals a downtrend.
MACD can also be used as a buy and line signal when used with a signal line. In case the MACD line passes atop the signal line, it is a buy signal. When it goes under the signal line, it is a sign to sell.
How You Can Trade with MACD
Investors use the MACD indicator for trading to establish the exit and entry points for trade and identify trends and their momentum.
1. Using MACD to Identify Trends
You can use MACD to identify and join a trend. The first important step for technical trading is identifying a movement and its direction.
Using the 200-day moving average can help you establish a trend, whether it is an uptrend or a downtrend.
Once you have identified a trend, you can use the MACD crossover to identify buy and sell opportunities. For instance, if the MACD line goes atop the zero line, then it is an upward trend. On the other hand, a crossover above the signal line signals an entry.
A MACD and signal line crossover will help you identify the entry and exit points of trend movement.
Trading trends always end, and traders should be alert to manage risk. They should look out for signals like a bearish crossover for signs of changing directions and slowing down uptrends.
Traders can use the MACD zero line to mitigate risk. Note that trends always end, and being alert to their slowing down movement can help you avoid risk. For instance, bearish crossovers are usually signs of slowing down of upward momentum.
For instance, if you are in a long position, you could use the opportunity to exit. When there are bearish crossovers, traders should look out for the single line crossing below the zero line, indicating a downward trend, an opportunity to exit a trade.
2. MACD Histograms
The MACD histogram is one of the most instrumental elements of the indicator. The bars in the histogram show the difference between the signal lines and MACD. When prices are moving at high momentum, the histogram height increases.
Essentially, the histogram bars move far from zero, whereas the moving average lines move further away from each other. The moving averages start coming close once the expansion is over, which is a sign of an impending crossover.
Traders use the reversal of the histogram to place their positions in a trade. The interesting thing about the histogram reversal strategy is that it can be implemented even before there are movements. Using the technique, traders can make profitable trades and establish the best time to exit.
3. Crossovers for Buy and Sell Signals
Traders can use the crossovers in MACD to identify buy and sell signals. As the MACD line passes atop the signal line, a buy signal comes in. If the MACD line goes under the signal line, it is a signal too short.
Note that the crossover buy and sell signals strategy is lagging in nature, meaning it is executed after movement occurs. The challenge with the strategy is sometimes there are weak MACD trends which can give false signals if the prices reach a reversal point. Traders should look out for false signs.
The MACD indicator is best used for trending markets. This means it can limit traders in other areas requiring different trading strategies. For instance, if you use the MACD indicator for consolidating markets, you will get flawed signals.
To use the MACD indicator, traders must understand it fully and when exactly to use it. The indicator is popular among advanced traders as beginners often have challenges using it initially. Understanding the fundamentals of the exponential moving average is therefore critical if you intend to use MACD.
Worth noting also is that the indicator is subjective, meaning the results may vary across different traders.
Some of the common trading strategies you can use with the tool include crossovers, histogram reversals, and trend identification.