By Vito Henjoto, Technical Analyst, GFT
MACD is widely regarded as one of the most widely recognised and used technical indicators, after Moving Averages. Created by Gerard Appel in the late 1970s, MACD was initially designed to detect changes in momentum, strength and direction in stock prices. In recent times, more forex traders have employed MACD to assist in intraday trading.
MACD is one of two indicators that provide an overall view of the market - the other being the Ichimoku Kinko Hyo, which I will cover in two pieces shortly.
Like it or not, every technical analyst and trader who is using technical analysis will come across this indicator in one-way or another. Most arguments against MACD stem from the delay when reacting to price changes. With that in mind, traders both experienced and new to the markets have to ask themselves: is it worth giving MACD a try?
Composition
MACD, which stands for Moving Average Convergence Divergence, consists of three different sets of signals, all of which are based on the EMA (exponential moving average) of price. The default settings of these EMA's are 12 EMA, 26 EMA and 9 EMA.
The difference between 12 EMA and 26 EMA forms the MACD line, with 9 EMA as the signal line and the last part of MACD; the histogram is the difference between MACD line and the signal line. The fast EMA will react quicker to price when compared to the slow EMA. The difference can provide subtle hints to any changes in price, which traders can compare against the signal line to detect changes in the prevailing trend.
This combination is the saving grace that differentiates the MACD to the normal Moving Averages. It is a common mistake to treat MACD as an indicator that has more lag when compared with a standard Moving Average; this is partly due to the use of several Moving Averages. The opposite is actually true as the histogram produced from the MACD line and Signal line previews the upcoming changes in a trend. This gives traders the opportunityto anticipate changes before they happen.
The Histogram simply represents the difference between MACD line and the Signal line. The further apart they are, the stronger the trend momentum is. It is also used as a tool to provide insight into various market conditions (how overbought/oversold is the market).
Interpretation
There are three commonly accepted ways to interpret MACD. These are Zero line crossover, Signal line crossover, and divergence.
Zero line crossover:
The zero line in this instance measures the difference between the 12 and 26 EMA; in other words, it measures whether the MACD line is positive or negative.
• When MACD is at 0, this indicates equilibrium between the 12 EMA and 26 EMA
• When MACD moves above 0, this considered bullish.
• When MACD moves below 0, this is considered bearish.
This is used to detect changes of trend in the market. This is normally the first thing traders should refer to when using MACD; to identify what is the current underlying trend.
Signal line crossover:
Signal line cross occurs when MACD intersects the Signal line. As the name suggests, some consider this to be the trigger to go long or short.
MACD x Signal line to the downside it gives a bearish signal/ sell signal
MACD x Signal line to the upside it gives a bullish signal/ buy signal
The two interpretations above are the more commonly understood ways to use MACD. However the next interpretation is the meat of the indicator; to the point where it is actually part of the acronym.
Divergence:
Divergence is a deviation between price and oscillator, with the logic that it will correct itself overtime.
Divergence gives an indication of possible trend changes and continuation.
There are different types and classifications of divergence, but generally the most commonly used divergences are Bullish and Bearish Divergence type A.
In the case of Type A divergences, a bullish divergence is represented by a lower low on price but a higher low in the MACD. A bearish divergence is indicated by price creating a higher high, while MACD is creating a lower high.
The histogram and MACD line is referred to when identifying divergences in the market. Choose either one not both. As I have mentioned earlier, there are various types of divergence, which I will cover in another article.
Divergence should be the main focus when using MACD when day trading as it provides changes in the market that remains undetected when using most indicators (with the exception of some oscillator type indicators that have similar capabilities).
Figure 1, MACD Progression from Divergence to a Sell Signal
Conclusion
While it can provide traders with a general feel of the market, MACD cannot be used by itself! Given it is an average of price, it will reflect market movement and momentum but not the range. Distances covered in price cannot be accurately reflected on MACD.
The best tools to accompany the use of MACD come in the form of price analysis - such as Fibonacci, Pivot points, chart patterns and candlestick patterns. Overall MACD is a worthy tool, one that can be used to complement most strategy. Its strength lies in the ability to gauge market condition and identify where price is in relation to trend.
Because of its relation with market trend, MACD is most effective when used in markets that tend to trade more rather than ranging.
Don't believe the myth that MACD is useless as an indicator. As with all things, with a better understanding of the indicator, it can be an effective tool to help you navigate the market better. Remember, I will be covering other subjects critical to traders such as Ichimoku and Divergence in the coming weeks, but in the meantime don’t hesitate to ask me any questions for TheBull's Ask The Expert section by clicking here.
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