What is MACD?
MACD stands for Moving Average Convergence Divergence.
This technical indicator is a method used to identify moving averages that indicate a new trend, whether bullish or bearish.
After all, finding a trend is a key priority in trading because it is where the most money is produced.
With a MACD chart, you will usually see three numbers that are used for its settings.
- The first is the number of periods that are used to calculate the faster-moving average.
- The second is the number of periods that are used in the slower-moving average.
- And the third is the number of bars that are used to calculate the moving average of the difference between the faster and slower moving averages.
For example, if you were to see “12, 26, 9” as the MACD parameters (which is usually the default setting for most charting software), this is how you would interpret it:
- The 12 represents a moving average of the previous 12 bars.
- The 26 represents a moving average of the previous 26 bars.
- The 9 represents a moving average of the difference between the two moving averages above.
There is a common misconception when it comes to the lines of the MACD.
There are two lines:
1. The “MACD Line“
2. The “Signal Line“
The two lines that are drawn are NOT moving averages of the price.
The MACD Line is the difference (or distance) between two moving averages. These two moving averages are usually exponential moving averages (EMAs).
When looking at the indicator, the MACD Line is considered the “faster” moving average.
In our example above, the MACD Line is the difference between the 12 and 26-period moving averages.
The Signal Line is the moving average of the MACD Line.
When viewing the indication, the Signal Line is the “slower” moving average.
The slower-moving average plots the previous MACD Line’s average. Again, in our previous example, this would be a 9-period moving average.
By default, most charts employ a 9-period exponential moving average (EMA).
This indicates that we are plotting the average of the last 9 periods of the “faster” MACD Line as our “slower” moving average.
The Signal Line’s aim is to mellow down the sensitivity of the MACD Line. The difference between the MACD Line and the Signal Line is represented in the Histogram.
It depicts the distance between the two lines graphically. It may occasionally offer you an early warning that a crossover is going to occur. When we look at our original chart, we can see that the histogram grows as the two moving averages (MACD Line and Signal Line) separate.
The faster-moving average (MACD Line) is “diverging” or moving away from the slower-moving average, resulting in a MACD divergence (Signal Line).
The histogram shrinks as the moving averages move closer together. This is referred regarded as convergence because the faster-moving average (MACD Line) is “converging” or approaching the slower-moving average (Signal Line).
That is how you get the name Moving Average Convergence Divergence, my friend! That one made us want to snap our knuckles!
So you now understand what MACD does. Now let us demonstrate what MACD can do for YOU
How to Trade Using MACD
Because there are two moving averages with varying “speeds,” the faster one will react to price movement faster than the slower one.
When a new trend emerges, the faster line (MACD Line) will be the first to react and will eventually cross the slower line (Signal Line).
When this “crossover” occurs and the fast line begins to “diverge” or move away from the slower line, it frequently suggests the formation of a new trend.
The fast line passed UNDER the slow line on the chart above, correctly identifying a new downtrend.
When the lines intersect, the Histogram disappears for a moment.
This is due to the fact that the difference between the lines at the time of the cross is zero.
As the decline begins and the fast line diverges from the slow line, the histogram expands, indicating a strong trend.
Consider the following example.
The fast line went over the slow line in the EUR/USD 1-hour chart above, but the histogram vanished. This suggested that the temporary decline might be reversible.
After then, the EUR/USD proceeded to rise as it entered a new uptrend. Imagine if you had gone long after the crossover and gained nearly 200 pips!
MACD has one disadvantage.
Moving averages, by definition, lag behind price.
After all, it’s merely a historical price average.
Remember, the MACD indicator consists of three components:
1. The MACD Line which represents the difference between two moving averages.
2. The Signal Line which is a moving average of the MACD Line.
3. The Histogram which is a graphical representation of the distance between the MACD Line and Signal Line.
That said, MACD is still one of the most favored tools by many traders.
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