What is MACD indicator

MACD is a technical analysis indicator created by Mr Gerald Appel in the late 1970s. Its full name is Moving Average Convergence Divergence. It is a mathematical construct derived from price (usually closing price of trading session) of underlying equity and provides a visual representation of direction, duration and momentum of price trend. Traders using MACD to trade have general positive reviews. MACD is able to show clearly:

  1. Direction of trend including signal for change in price trend
  2. Strength of price trend shown clearly by the MACD Histogram
  3. Changes in momentum of price trend appears as a divergence in both the MACD line and the MACD Histogram
  4. Crossing of MACD and its signal line provides buying and selling trade signals

Because of the way it is constructed, MACD is a very powerful indicator that can be used to ride price trends during rallies. It does not perform as well during ranging situations. The MACD Indicator can be used for trading forex in multiple time frames.

 

4 components of a MACD indicator

The MACD indicator consists of four components:

  1. MACD Line – The MACD line is usually printed in blue. It is the difference between the 12 and 26 Exponential Moving Average (EMA) of closing price. It is usually blue in colour.
  2. The Signal Line – The signal line is the 9 EMA of MACD line. It is usually red in colour.
  3. The MACD Histogram – This is the difference between MACD and its signal line.
  4. The zero-line – A horizontal line where y-axis value=0 which is an important indication of trend.

 

Trading signals coming from the MACD indicator

MACD indicator provides a number of signals. The is no single most important trading signal. Putting them together can however provide a picture of price and can be put into a trading strategy.

 

Signal #1 – MACD line cut zero-axis

The zero-line is a very handy way of telling price trend. When MACD > zero, price is on uptrend. When MACD < zero, price is on downtrend. Therefore, MACD cut zero-axis is a signal that shows change in trend.

Use of MACD zero-line

Use of MACD zero-line to determine trend

Reading MACD signal line in conjunction with zero-line shows underlying price trend

 

Signal #2 – MACD line (blue) cuts signal line (red)

The dummy’s way to read this signal is ‘cross up buy, cross down sell’ which is partly right but mostly wrong.

 

Uptrend - First of all blue line cross up red line (MACD > signal) is a change from negative to positive momentum. In an uptrend (MACD>0), this shows price moving from consolidation/retracement mode to rally/continuation of previous up trend. This can be indeed be treated as a buy to open signal. On the other hand, blue line cross down red line (MACD < signal) in an uptrend shows price changing from positive to negative momentum. This is the end of the rally mode and the start of a consolidation/retracement mode. To use as a trading signal, (MACD < signal) should be treated as a sell to close signal i.e. taking profit a position, not starting a short.

Downtrend - The converse is true. In a downtrend (MACD<0), blue line cross down red (MACD < signal) is signal to sell to open while blue line cross up red (MACD > signal) is signal to buy to close.

The signals describe above represent high probability trading signals for use to trade with the trend. Since MACD is a trend indicator, the signals represent the highest probability setups to profit from trading by riding the trend. Visually, when the MACD line is equal to is signal line, the value of the MACD Histogram is zero. Momentum is finely balanced like on a pivot or fulcrum. When the MACD histogram is the highest, the distance between the MACD line and its signal line is the widest and shows price momentum at its strongest.

Use MACD signals as buy/sell indicators

Use MACD signals as buy/sell indicators

In this context, blue star (MACD>signal) sends ‘buy to open’ signal to continue with the trend whereas a red star (MACD<signal) sends to ‘sell to close’ signal to take profit

 

Putting together a trading plan with MACD

MACD is a very rich indicator that can tell comprehensive picture of price. There are also special phenomenons such as ‘divergence between MACD and price’, ‘price divergence’ and ‘MACD Histogram’. But these belong to another article. Also MACD can be used extremely profitably in conjunction with other technical analysis studies like chart patterns, moving averages, horizontal support resistance, trendlines and candlesticks.

Forex traders must also take note of this important message. Trading indicators are not a trading plan. It is a part only. A sophisticated and mature trader understands that not all trading signals should be traded. Good trades come from patiently waiting for high probability setups. Good trades should ride with price trend rather than counter-trend. Good trading outcomes come from holding on to winners while cutting losers. Understanding all this means that trading indicators become even more powerful because they act as filter to help the trader implement his strategy.

In addition, a trading plan has to include money management techniques that utilize the trading capital effectively while managing trading risk. It should also take in account individual psychology.

It is with this view in mind that an individual with a strong motivation can learn all about trading indicators online but a good trading course will cut his learning journey even more by presenting an entire trading plan and shortening the learning curve.

For best MACD trading outcome, combine with important elements of price action, volume into a comprehensive approach.

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Soh Tiong Hum is Director of TerraSeeds Market Technician Pte Ltd. TerraSeeds is a trading educator in Singapore since 2005.   Soh's Twitter account @sohtionghum was ranked #23 out of The Top 70 Twitter Accounts To Follow In 2015 by MahiFX.   Disclaimer notice: "I do not have a financial advisor's license. I am not qualified by any regulator to give financial advice. I do not know you the reader. Your investment means and motive may be different from me. My posts here are based on observations and meant for education. I am not responsible for for any consequence from your actions."