How to use the MACD Indicator

April 25, 2013 07:56 AM

The acronym MACD stands for Moving Average Convergence Divergence and was invented by the famous technical trader Gerard Apel in 1979. MACD has a number of uses and is very popular among technicians. It can be used as a trend indicator, momentum indicator, it can measure divergence and it can also be combined successfully with other indicators.

The MACD works by calculating the difference between two moving averages (usually the 26 day and 12 day EMA) and is presented on a chart using two lines and a histogram.

MACD

The MACD appears with 3 numbers next to it, usually 12,26,9. 12 represents the number of bars that is used to calculate the fast moving average and 26 is the number of bars to calculate the slower average. The differences of the two moving averages (12 and 26) are represented by the two lines and the third number (9) is represented by bars, known as a histogram. This third number represents the difference between the two lines.

A common misconception is that the lines on the MACD represent the MA of the price but this is in fact not the case. Rather, the lines represent the moving averages of the difference between the two moving averages. It can sound quite confusing so let’s see how the MACD can be used in trading decisions.

Crossover

A common way to trade MACD is using the crossover strategy. When the fast line crosses above the slow line it is often a signal that a new uptrend has started and is often a good place to buy. When this occurs it can be said that the difference between the two moving averages is diverging at a faster rate. Similarly when the fast line crosses below the slow line it is a good time to sell. As can be seen from the chart, this strategy would have made a nice profit on 11 April of about 40 pips.

How to trade with MACD example chart

As you can see, the histogram has a figure of zero when the crossover takes place since there is no difference between the two lines.

Momentum divergence

Another less well known way to use the MACD indicator is by comparing the relative strength of the indicator compared to the market.

For example, let’s say that the market is in a long term up trend and has just made another new high. We can look at the MACD indicator for confirmation of the momentum in the market. If the market has made a new high but the MACD indicator hasn’t it indicates that the market is running out of momentum – since the rate of divergence between the two moving averages is declining. This strategy can work just as well for a down trend too.

A good example of this is shown in the below chart. As you can see, EURUSD was in a strong down trend and posting new lows relatively consistently. However, even though the market was making fresh lows, the MACD indicator was actually shown to turn upwards and indicated that a change in direction was imminent. Thus the upward movement of the MACD indicator showed downward momentum was slowing and would have been a good opportunity to buy.

How to trade with MACD example chart


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