What is MACD in trading?
‘MACD’ is short for Moving Average Convergence Divergence. Invented by Gerald Appel in the 1970s, it’s a popular indicator that can be used to spot trends that help traders work out when to enter a trade.
How does the MACD indicator help traders spot potentially profitable entry and exit points? Convergence and divergence. MACD trading strategies plot moving averages on a price chart. For example, if you’re looking at MACD in stock, you’d plot two moving average lines on a share price chart. Then, depending on whether the lines move closer to each other (converge) or further away (diverge), you can make decisions.
The possible conclusions you can draw from these contrasting movements are explained later in this guide to MACD. For now, just know that converging averages suggest momentum is decreasing. In other words, the rate of change (either positive or negative) is slowing down.
If the averages are diverging, it’s a signal that momentum could be building i.e. the price is changing at a faster rate. Once you have an insight into an asset’s price momentum using the MACD indicator, you can start to make decisions on whether to buy or sell and, indeed, when to enter and exit positions.
How does MACD work?
Essentially, MACD is a trend momentum indicator that takes two moving averages and works out the difference between them. Click here for more information about moving averages. MACD turns the two moving averages into a momentum oscillator which makes it easier for the trader to visualise.
The standard MACD has three main components. To illustrate what a MACD signal looks like in practice, check out the image above. Below the main candlestick price chart, you’ll see three lines in red and/or yellow. These lines are the three components of a MACD indicator:
The MACD Line
The MACD line is shown in yellow in the example above. It can also be represented by a blue line. Whatever colour it is, this is the main point of focus. The MACD is derived by subtracting the 12-day Exponential Moving Average from the 26-day Exponential Moving Average.
The Signal Line
The red line (sometimes a dotted line) is the signal line. This is the nine bar Exponential Moving Average of the MACD.
The last component of the MACD indicator is the histogram. A histogram is a bar graph. You can see from the image above that it’s represented by a series of different-sized lines. These lines show the distance between the MACD and the signal. For example, if the MACD is above the signal line, the histogram (i.e. the lines on the graph) will be above the MACD line.
If the MACD is below the signal, the histogram will be below the MACD line. When the histogram is above the MACD, it suggests momentum is bullish. When it’s below, the MACD signal suggests momentum is bearish.
More MACD Signal Examples
You can use MACD in forex and when you’re trading shares. Regardless of the asset you’re trading, a MACD indicator will always feature the three components listed above. From this, you can get an idea of the direction an asset’s price is moving and how much momentum there is based on the distance between the MACD and signal.
Finally, when the two lines cross, this can be used as a signal to buy or sell. People using MACD trading strategies believe that it’s a bearish signal and time to sell when the MACD line falls below the signal. Conversely, when the MACD line rises above the signal, traders believe it’s a bullish signal and time to buy.
The following images show examples of these movements with MACD in forex and MACD in stock trading:
MACD in Stock Trading: Tesla Shares
The image above shows a crossing point just after the 16:45 mark, suggesting a bullish turn for Tesla shares. You can also see that, for a large portion of the chart, the bars on the histogram are small. This shows that the gap between the MACD and signal is small which, in turn, suggests there isn’t a lot of momentum.
MACD in Forex: XRP/EUR
As you can see from the image above, the MACD line (in blue) drops below the signal line before the 06:00 mark, signaling bearish momentum. It quickly crosses back over and becomes bullish.
How to trade with MACD
MACD is a really useful indicator for spotting short-term moves and a lot of traders use it to time their entry into the market. There are three main methods to do this:
Main MACD methods:
- When the MACD line turns down and crosses below the signal line, that signals a downward trend.
- When the MACD line turns up and crosses above the signal line, that signals an upward trend.
- As the histogram shows the difference between the two averages, it can be used to predict the strength of the trend – the bigger the histogram, most often the stronger the trend.
- As an oscillator like RSI and Stochastic, divergences may occur to foreshadow a trend reversal.
Be careful though… MACD can provide false signals like any other indicator so it’s better to use it in combination with other indicators, like RSI and Price Action.
How to add MACD
- Adding MACD to your Skilling charting platform is simple:
- Type MACD into the indicator dropdown menu and select MACD.
- The settings screen for the MACD are now displayed.
- You can use the default input data or enter your own. You can also change the colour settings for your MACD chart.
- Click the OK button to add the MACD to your charting platform.
MACD vs. RSI
The MACD signal is a useful way to judge the momentum of an asset. Another technical indicator that shows something similar is Relative Strength Index (RSI). The RSI gives you an indication of whether or not the market might be overbought or oversold. It does this by calculating an asset’s gains and losses over a specific period of time.
That’s similar to MACD. However, RSI is different because it measures price changes in relation to highs and lows. In other words, RSI looks at how the current price average compares to recent high and low points. The MACD indicator looks at price averages in relation to each other.
Therefore, people who use MACD trading strategies will also use RSI when they’re trading CFDs, shares, forex, and other financial instruments. Using both technical indicators can give you a better overview of an asset’s price movements, momentum, and how current values sit in relation to recent highs/lows.
MACD is another popular indicator and one you are likely to come across often. Traders like it as it provides different ways to generate signals and also can give indications on trends. So, if you are the type of trader who would prefer to only look at one indicator when you trade, then perhaps MACD might be for you.
Enhance your knowledge of trading and refine your MACD trading strategy with these resources:
Not investment advice.
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