If you’ve ever looked at a trading chart with two wavy lines and a series of colourful bars below the price line, you’ve seen the MACD. This indicator has become so popular because it provides both trend direction and momentum information in a format that is easy to understand. However, the downside of its popularity is that many new traders either don’t pay attention to it, or they use every single cross over signal as an entry/exit point. In this article I’m going to provide you with some basic understanding of what the MACD does, how to interpret its components, strategies by traders, what settings work best for varying time frames, and how to detect the false signals that often confuse new traders.
What Is the MACD Indicator and How to Calculate?
MACD stands for Moving Average Convergence Divergence. Created by Gerald Appel in the late 1970’s, it is to measure the relationship between two different types of exponential moving averages (EMA’s) of price. Since an EMA provides more significance to the most current prices than the previous prices, it will react quicker to changes in price than a typical moving average. The Stock Charts Chart School guide offers extra examples if you want to practise.
Image 1: A price chart is at the top of the image. Beneath the price chart is a MACD panel. The blue MACD line and the orange signal line are moving around a dashed zero line. Green and red histogram bars represent the distance between the two lines. As the momentum increases, so does the height of these bars. When the momentum decreases, so does the height of these bars.
Further Ahead
The following describes how you can interpret each component. The MACD line represents momentum, when it is above zero, the short-term average (fast average) is greater than the long-term average (slow average), which indicates a possible upward trend. Conversely, when the MACD line is below zero, the opposite is true. The signal line is a smoother version of the MACD line, and serves as a point of reference. The histogram is the distance between the MACD line and the signal line. Large green histograms indicate increasing buying pressure; however, smaller histograms represent decreasing momentum prior to the lines crossing. Since the histogram changes before the MACD line, some traders use it as an early indicator.
The zero line should be thought of as a way to measure the “mood” of the market. High readings above zero in a rising market indicate strong buying pressure, but may also indicate that the price has moved too far. When the MACD remains relatively close to zero, it means that the market is in a state of indecision and that trend following strategies will likely not be profitable.
MACD Trading Strategies and Crossover Signals
The first major type of signal with the MACD is a crossover. The MACD produces two types of crossovers, the bullish crossover and the bearish crossover. A bullish crossover occurs when the MACD line moves from below the signal line to above the signal line. This indicates that buyers are starting to gain control of the market. Conversely, a bearish crossover occurs when the MACD line moves from above the signal line to below the signal line.
What this indicates?
This indicates that sellers are beginning to take control of the market. In addition to these two types of signals, there is another common type of MACD signal-the zero-line cross. When the MACD line crosses above the zero-line, it confirms an upward trend in the price of the security. On the other hand, when the MACD line falls below the zero-line, it confirms a downward trend in the price of the security. Lastly, there is a third type of signal using the MACD. This signal is the divergence.
Image 2: A price chart with a MACD panel
More in depth
Crossovers are most effective when they align with the larger trend. When there is an upward trend, use bullish crossovers below the zero line as opportunities to enter on pullbacks, and ignore bearish crossovers until the trend changes. Set a stop-loss above the most recent swing low, and look to make at least two times what you’ve risked. Many traders also wait until the current candle closes prior to entering trades since crossovers that appear during the candle may disappear after it closes.
A straightforward way to practice on a demo account is: Find the long term trend on a larger time frame; wait for a retracement of the trend; trade the trend after the MACD crosses over again in Favor of the trend; and exit your position when either the MACD histogram begins to shrink or there is an opposite MACD cross-over. Keep track of what happens using a journal, and then you can determine if the strategy actually works.
Do remember
Before you begin trading, I would like to offer a word of caution regarding risk. Although strategies may appear to be clean and simple when presented on paper; in reality there will always be spreads, slippage, and most importantly, emotion involved in every trade. A strategy that produces a profit forty percent of the time could produce profits if the winning trades are larger than the losing trades by two-to-one. Conversely, a strategy that produces a profit seventy percent of the time may produce losses if a single bad trade causes loss of multiple winning trades.
Therefore, it is important to assess your performance based upon a large number of trades as opposed to just a few. You should also record each entry and exit along with your rationale behind those decisions. It would be beneficial to evaluate those records on a weekly basis. This process will teach you more than any individual indicator possibly can.
Best MACD Settings for Different Timeframes
There is no one “best” setting for the 12-26-9 parameter on a daily chart. It is created in a time when most people used daily data, therefore, it is a good starting point for use with daily data. However, the correct setting will depend on how you trade. A faster setting may result in more signals but also more false signals (noise). On the other hand, a slower setting may result in fewer signals but they will likely be more reliable.
Day trading using 1–15-minute charts is done with a faster combination (i.e. 5-13-5 or 8-17-9) to decrease the amount of time delay. Swing trading on 4-hour and daily charts typically use 12-26-9. Position trading on weekly charts may increase the number of periods used, such as 19-39-9, so that they can avoid short-term price fluctuations.
Once you’ve made your decision, run it. At least 50 of the most recent trades in the markets that you are trading should be run with the new setting. Keep track of how many trades were successful and compare those numbers to the previous settings. One of the biggest mistakes beginners make is to change their settings after each failed trade; therefore, before you start testing the new settings, make sure that you will let the strategy perform for a reasonable amount of time.
MACD Limitations and How to Avoid False Signals
No single technical indicator is without flaws. The MACD has some very distinct disadvantages. The MACD uses moving averages which causes the indicator to lag behind price action.
In sideways markets it produces repeated crossovers that lead to small losses, a situation traders call a whipsaw . It also says nothing about volatility, volume or fundamentals, so a strong signal can still fail if news hits the market.
How do you filter for trend?
You start by filtering for trend; then you take only those signals that align with either the higher time frame or the 200-period moving average. After that, you’ll need confirmation of some sort, such as a candle closing past a support/resistance level. Additionally, you will want to avoid crossovers when the MACD line is close to zero since this is generally an indication of a range. Lastly, use MACD with price action and good risk management. By risking only 1%-2% on each trade, you can survive a losing streak.
Image 3: This image displays a price chart that has created a higher high than the previous high. Below it is the MACD (Moving Average Convergence Divergence) panel, which has created a lower high than its previous high. There are dashed lines drawn from the highest point on each chart, showing how they diverge from each other. This is an example of “bearish divergence.” Bearish divergence signals to traders that there may be a decrease in the strength of an existing uptrend.
The third image demonstrates how to use the Divergence tool, which is an excellent way to determine when a trend may be coming to an end. However, as noted before, a divergence can last for some time. Therefore, think of it as a sign of caution rather than a signal to enter or exit a trade.
Frequently Asked Questions About the MACD Indicator
What are the best MACD settings for day trading?
There is no single correct answer for this, however, several day traders utilize faster settings (such as 5-13-5 or 8-17-9) when using one to fifteen-minute charts. Although faster settings respond faster, they also generate more false signals. To minimize the negative effects of the additional false signals generated by the faster settings, you should combine these faster settings with a trend filter and tight stops. In addition, prior to risking real capital, it is highly recommended that you test these faster settings on a demo account.
Is the MACD a leading or lagging indicator?
Mainly delayed, as it is based on the average price of an asset over time. Although the MACD histogram and the divergence may give some indication of a shift in momentum slightly before other indicators, they will not accurately indicate when a reversal is likely to occur. It should be used as a tool to confirm other signals rather than as a predictive tool.
What is the difference between MACD and RSI?
MACD measures the relationship between two different types of moving averages, but because it does not have a limit on how high or low it can go, it can be used to measure both trends and momentum.
The relative strength index is bounded between 0 and 100 and highlights overbought and oversold zones. Many traders use the MACD for direction and the RSI for timing.
How do you trade MACD divergence?
Bearish divergence occurs when prices are higher than they were during the previous period, but the MACD is lower than it was during the same period. The implication of this is that the trend toward higher prices is slowing down. Conversely, bullish divergence occurs when prices are lower than they were during the previous period, but the MACD is higher than it was during the same period. As soon as you see either type of divergence, wait until there has been a crossover of the MACD or a break of the closest support area before making a trade. Then put your stop loss at a level that would be below/above the most recent price extreme. This article is meant to be educational; it should not be considered as professional financial advice.
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