The MACD indicator – pronounced “ MAC – dee“ or “M-A-C-D“ – is a popular and versatile tool, which generally appears as a histogram at the bottom of charts, with a line following it called the signal-line and a second horizontal line through the centre called the zero-line, above and below which the MACD oscillates.
Traders use the MACD to analyse momentum and measure the strength of the trend. They look for divergences and convergences between the MACD and price to indicate potential market turning points, and use the MACD crossing its signal-line for trade entry and exit signals.
The MACD is calculated by subtracting a long exponential moving average of the price from a short exponential moving average. The signal-line is itself an exponential moving avergae of the MACD and the zero-line is the point at which the averages would cross if seperated.
Signals are generated in 3 main ways:
a)The MACD crossing the signal-line gives trend reversal signals. It is particularly accurate at overbought and oversold extremes.
b)The MACD crossing the zero-line tends to give a confirmation of the trend.
c) Convergences and divergences of MACD with price reveal underlying strength and weakness in the trend, in the same way as regular momentum oscillator does.
What a lag
MACD is said to be a lagging indicator and this is often percieived as a disadvantage, however, it can also prevent traders from entering the market too soon. In the chart below, for example, note the topping candlestick formation – a shooting star.
It would be tempting to short the market at this point, however, if we looked at the MACD we would notice it has not crossed below the signal line. In fact the contray is true, MACD has crossed above the signal line giving a bullish buy signal instead. In the end the market continues higher and if we had sold short the set-up we would probably have been stopped out.
Now look at the diagram below showing a similar shooting star . Note, however, that on this chart the MACD has crossed below the signal line, giving a sell signal.
In the end the confirmation from MACD’s signal line actually results in a better trade and the market falls steeply.
Whilst signal-line and zero-line crossovers are useful, on their own they can result in many whipsaws. For a higher probability of success it is best to combine them with divergences and convergences.
One strategy is to look for convergence or divergence for the intial set-up and then wait for the MACD to cross the signal-line before taking the trade. The crossing of the zero-line can often be a good place to take profit.
For example in the chart below we see that the market rallied to a peak of 1.2844 on the 12th of January before correcting. Then the market recovered and resumed its rally, making an even higher high at 1.2878 on the 13th Jan. The MACD rallied too but unlike price it failed to make a higher-second high thus giving rise to a divergence.
A short order was entered and triggered when the MACD crossed below its signal-line at 1.2829. The price then fell until the trader exited when the MACD closed below its zero-line, winning an impressive 100 pips in the process.
Trading strategy enhancements
One drawback of convergences and divergences is that they can give rise to false signals when the market is trending strongly.
In the chart below, for example, you can see that despite a convergence between MACD and price the market continues to fall and makes an even lower low, and if the trader had bought on the first convergence he would have been stopped out.
The market makes a second convergence and a final low and it is only then that it recovers and makes a substantial rebound.
One neat solution to the problem of convergence and divergence failure, proposed by an analyst named Boris Schlossberg, is to use the MACD as a guide to placing stops rather than the price. In the chart above the intial convergence failed and the market went lower. If the trader had placed his stop at the lows he would have been stopped out. The MACD did not make a lower low however resulting in a second convergence, which again indicated underlying weakness.
Only after that did the market reverse and rally. If the trader had used the MACD rather than the price to place his stop he would have remained in the trade despite it initally turning against him and making a new low.
Using this approach the trader not only avoids unnecessary losses from early entry but also can build a position of new trades opened at each instant of divergence or convergence. The position is only stopped out if momentum increases and re-confirms the trend. In truth it is rare to get incidences of more than three convergences or divergences in a row before the final break.
This technique is particularly suited to the forex trading because of the greater margin available, which allows traders to build positons with relatively little capital, and suffer bigger drawdowns without margin calls.