Today we are going to discuss how to effectively use the MACD technical indicator as a tool to build a higher level of conviction in your trading entries.
We are going to explore ways in which we can use this indicator effectively within a trading strategy to ensure that we are only taking the highest quality of trade setups.
The moving average convergence divergence technical indicator, commonly known as the MACD is a widely used indicator developed in the late 1970s by the famous Technical Analyst Gerald Appel. The MACD visually conveys the changes in strength, direction and momentum of price trends by means of tracking the relationship between two separate moving averages of price. It is one of the most common technical indicators used in all kinds of markets around the world and on all different timeframes.
Due to the way the MACD is derived (from the history of movements of price), it is a lagging indicator. This means that signals to buy and to sell given by the MACD (which we will get to shortly), come a number of candles after the ideal point to enter or exit a trade. This, however, does not mean the MACD cannot be an extremely useful component of a trading strategy. Before I explain how it is used most effectively, we must first discuss how it works and how the information it conveys can be interpreted.
Figure 1: MACD Diagram
As can be seen in Figure 1, the MACD indicator is made up of two lines, the MACD line and the signal line, which move above and below the base-line (the middle line) of the indicator. The MACD line is made by plotting the difference between two exponential moving averages of price. The signal line is an exponential moving average of the MACD line. This means the MACD line will always be quicker to react to changes in price and trend conditions than the signal line. The relationship between the two of these lines is displayed graphically in the form of a histogram. When the MACD line is above the signal line, the histogram shows positive (bullish) momentum. Conversely, when the MACD line is below the signal line, the histogram shows momentum to the down side (bearish). As is the case with many different types of technical indicators, the MACD is most effective when used with the default settings. These are generally 12, 26, and 9, for fast, slow and signal/smoothing, respectively. As always, I still encourage you to experiment with different settings for the MACD indicator on your own technical analysis platform to see how it affects the visual appearance and signals given by the indicator.
Figure 2: Bullish vs Bearish MACD Histogram
There are many common ways that the information the MACD indicator conveys can be interpreted. The most widely used method is to take signals to buy and to sell when the MACD line crosses above (buy) and below (sell) the signal line. Another way to interpret the same series of signals would be to buy when the histogram changes from red to green (bullish crossover), and to sell when it changes from green to red (bearish crossover).
Although some of these signals will result in great trading opportunities, you must be aware that due to the MACD being a lagging technical indicator, these signals will generally come after the ideal time to buy or to sell has already passed. Another consideration that must be made when identifying these kinds of trading signals is that there will often be substantial “noise” produced by the indicator where the lines cross over back and forth in a short period of time. These “noise” signals must be identified and disregarded as they are not worthwhile trading opportunities. The best way of identifying “noise” when reading any trading indicator is by intuition which comes with experience.
Another way to use the MACD indicator is to determine the strength and momentum of the current trend. The easiest way to gather this information with a glance of the MACD is to note whether the consecutive bars of the histogram are currently growing larger or smaller in size in relation to previous bars. If the bars of the histogram are increasing in size, this tells us that the strength and momentum of the current trend of price is increasing. If the bars of the histogram are decreasing in comparison to previous bars, the momentum of the current price trend is weakening. An effective way to implement this kind of trend momentum analysis into your own trading is to examine and identify confluence between the current MACD trend on multiple different timeframes as well as the one on which you are basing your trading entries and exits.
The way that the MACD is most effectively used within a trading strategy is to not rely on any of the signals it gives for defining your entries and exits. Instead, it is an excellent tool for confirming entries given by other technical indicators such as the stochastic (see previous post), price action, or the order book.
Trading solely off the MACD signals alone, like with many technical indicators, will result in some excellent trades but likely equally many (in some cases more) substantial losses.
To be used effectively, the MACD indicator must be combined with other variables within a trading strategy, as a means to build conviction and confirmation to ensure you are only taking the highest quality of trade setups. It is an excellent tool to add to your own trading arsenal and with practice and experience, you will be able to use it to significantly increase the win rate of your own trading strategy and the conviction of your ideas.
If you would like further information or examples, check out our video at the following link: