How to use the MACD Indicator and trade with the trend.
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In this video, we discuss what is the MACD indicator and how can you use it for profitable trading
The MACD or Moving Average Convergence Divergence is a trend-following momentum indicator that measures the relationship between two moving averages. It is plotted as an oscillator at the bottom of the price chart and shows the strength of the prevailing trend along with signals of the change in trend.
It can also be plotted as a histogram, which moves above and below the baseline, showing strength and weakness in price.
The MACD indicator can be applied on any time frame from 1 minute to monthly charts, making it useful for all kinds of traders including intraday, swing and positional traders.
Here is a chart of the popular stock Tesla with its MACD plotted at the bottom. The MACD indicator in this timeframe provides multiple trading signals on the long as well as the short side.
As can be seen in the chart, the MACD indicator is made of two lines, that oscillate, cross each other often, and then go up or down together for extended periods.
Let’s look at how the MACD is constructed
The blue line in the indicator is called the MACD line, which is plotted using the values derived by subtracting a longer-term exponential moving average from a shorter-term exponential moving average of the price.
The 12-period and 26-period exponential moving averages are most commonly used in the MACD indicator. You can always change these parameters based on your preference.
The MACD line keeps on changing with the price and oscillates above and below zero, which represents the baseline.
If the subtraction of moving averages results in a negative number, the MACD line slips below zero. This will be the case when the short-term moving average is lower than the long-term moving average. In other words, the price is in a downtrend or moving sideways.
Alternatively, when the MACD line is above the baseline, the short-term moving average will be higher than the long-term moving average, representing an uptrend.
The second line or the red line in the MACD indicator is the signal line.
This line is plotted on the top of the MACD line and is the exponential moving average of the MACD values for a stipulated time frame.
A 9-period exponential moving average is most commonly used for the signal line.
Traders use the crossovers between the MACD line and the signal line as trading signals. A bullish signal is when the MACD crosses above the signal line and a bearish signal is when the MACD crosses below the signal line.
When the MACD indicator is presented as a histogram, each bar represents the distance between the MACD line and the signal line.
When the MACD line is above the signal line, green bars are formed and when it’s below the signal line red bars are formed.
The bigger the bars, the larger the distance between both the lines, and the stronger is the trend.
Let’s now understand how to use the MACD Indicator in Trading
While theoretically, the MACD indicator sounds quite straightforward, in practice it’s a lot more subjective and has to be interpreted skillfully for successful trading.
It’s essential to understand how the MACD indicator behaves during different price actions and when the signals should be pursued and when to be ignored.
MACD is best to trade the trending prices. In choppy and volatile markets, MACD will whipsaw, with frequent crossovers between the signal and MACD line. Trading in such environments will only increase the portfolio volatility while delivering marginal returns or losses.
As MACD is a lagging indicator, it is best to mix MACD with a couple of basic trend tools like trend lines and dow theory to make good trading decisions.
For example, in this chart, when the price was rangebound there were multiple crossovers between the MACD and signal line, but no follow through on the price.
It was only when the price broke through the channel and started trending, the MACD signal proved to be rewarding.
That is the kind of confirmation we need to look for, along with the MACD signals to get on to profitable trades.
There would be numerous other ways to use the MACD indicator to complement your trading. All you need to do is to figure out the combinations that work for you and practice them enough to develop an edge.
Once you have the edge, your trading will become much more profitable and much less stressful.
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