Moving Average Convergence-Divergence
The MACD is perhaps the most popular technical indicator. The moving average convergence-divergence is an indicator which combines two unique features: oscillation and momentum. It is created from the difference between two moving averages and it is set to oscillate about a mean, or the zero line. The MACD can be used in many ways and there are several methods for reading it. The three main ways a trader can use the MACD is a signal-zero line crossover, a signal-MACD crossover, or divergences.
The Mathematics behind the MACD
There are three elements of the MACD of which the astute trader must be aware. They are the MACD, the histogram, and the signal. The MACD is found by taking the difference between two moving averages (typically the 12 and 26 moving average). While the moving averages are trending upwards (12 EMA above the 26 EMA), the MACD is above zero. While the moving averages are trending downwards (the 26 EMA above the 12 EMA), the MACD is less than zero. The signal line is found by taking a 9 period exponential average of the MACD. The histogram is found by taking the difference between the MACD and the signal line. We have included a chart showing the MACD indicator with all of the items labeled.
The Typical MACD
The standard moving average settings are 12, 26, and 9. This means that a 12 period and a 26 period exponential moving averages are used to create the MACD and a 9 period exponential average is used to generate the signal line. Before trading with the MACD, an individual is encouraged to explore various settings to determine which is most appropriate for his needs. We have found that after much exploration for the ?perfect? settings, most traders return to the default. Also, because the MACD appears on many traders? charts, it may aid the user to ?see what other traders are seeing? and use the default settings.
Below we have included some of the most popular MACD strategies which trader will frequently use in the financial markets.
Method 1 - Signal Line Crossover
The first method which many traders use is the signal line crossover. The signal line crossover occurs when the signal (which is a 9 period EMA of the MACD) crosses above the zero line. When the MACD crosses over the zero line, it is in effect a moving average crossover between the 12 and 26 period exponential moving averages. As the trader may recall, moving averages can crossover in rapid succession while price is in a trading range, leading to ?whiplash? or buying and selling multiple times as the trend changes. By trading off of the signal crossing above zero, the trader is filtering out many of the false crossovers and trading with the average of an average. By trading with the signal line, traders are better able to avoid poor trades which they would have perhaps taken according to moving average crossover criteria. As always, it is necessary for the trader to gauge the stage of the market and only initiate trends in the direction of the primary trend.
Summary - Trading the Signal Line Crossover
1. Draw key support and resistance levels to determine if price is range-bound or trending.
2. When the signal line crosses above zero and price clears near-term support or resistance, place a trade in the direction of the crossover.
3. Nimble place stops beneath or above prior retracements.
4. When the signal line starts to ?top out? or ?bottom out?, returning towards the zero mark, tighten stops and consider taking profit.
5. Exit when a stop is hit or the signal line crosses back over the zero mark.
6. Never trade against the primary.
Method 2 - MACD-Signal Crossover
Another form of crossover which traders will typically employ is the signal-MACD crossover. This crossover is similar to a moving average crossover in that when the faster of the two averages crosses above the slower, an uptrend is present. When the slower of the two crosses below the other, a downtrend is present. In the MACD indicator, the signal line can be considered the slow average and the MACD can be considered the quick average. When the MACD crosses above the signal line, this is a good signal to go long and when the MACD crosses below the signal line, this is a good moment to short. In the ideal world, a crossover would work every time, however the real world is far from perfect. In order for a trader to profit off of a MACD-signal crossover, he must factor in price action as well as key levels of support and resistance. He should never trade against the primary trend and he must always enter and exit on his specific criteria.
Summary - Trading the MACD-Signal Crossover
1. Draw key support and resistance to determine if price is trending or consolidating.
2. If price is free of a trading range or it is in a trend, purchase when the MACD crosses above the signal line or sell when the MACD crosses below the signal line.
3. Set initial stop below (or above) a prior retracement.
4. Move stops beneath prior retracements as they form.
5. Exit when a stop is hit or the MACD crosses back over the signal line.
6. Never trade against the primary trend.
Method 3 - Divergences
Perhaps the most powerful feature of the Moving Average Convergence-Divergence is its ability to spot reversals through the use of divergences. Divergence simply means that price travels one direction while the indicator travels another direction. Since the MACD is a momentum indicator, when it increases in value, it means that the security is gaining upward momentum. When the MACD is decreasing in value, this means that the security is losing momentum or gaining downwards momentum. If the MACD travels downward while price travels upward, this is a divergence. The price and the MACD are telling two different stories. For the most part, when the price and the MACD are diverging, the MACD is typically correct. This offers traders an excellent opportunity to catch the top of a move and capitalize on a reversal. A divergence between price and the MACD typically leads to a reversal. When a trader is physically drawing the lines to identify a reversal, he must be mindful to draw lines tangent to the histogram part of the MACD indicator as well as the peaks or troughs of the price moves which created the peaks or troughs of the indicator. In the following diagram, we have portrayed the concept of divergences as well as optimal entry and exit points.
Summary - Trading Divergences
1. Draw key support and resistance as well as trend lines to show the best moments to trade.
2. Draw trend lines on the peaks or troughs of the MACD and corresponding price action to spot a divergence.
3. Initiate a trade as soon as price clears near term support or resistance in the direction of the reversal.
4. Set initiate stop below or above prior retracement.
5. Move stop to more prior retracements as they develop and clear.
6. Never trade against the primary trend.