MACD: how to use momentum for the greater accuracy

The MACD indicator is a variation of the moving average crossover and represents a smoothed difference between two exponential moving averages.

The moving average convergence-divergence is one of the most potent technical tools in trader’s arsenal.

It is also one of the simplest and extremely versatile, as it can be used both to trade trend and the range.

The moving average convergence-divergence indicator is based on the insight that more can be learned about price behavior from the interaction between moving averages than from the moving averages themselves.

So let’s take a closer look.

The MACD is created by:

forming a short term and long term smoothed trendline from the original price series,
subtracting the long term from the short term, and finally,
applying another smoothing to the newly generated prices.

Here’s the point.

We are taking two trend-following indicators (moving averages) and turning them into a momentum oscillator.

Changes in the momentum precede changes in price

One of the major technical analysis concepts is that the change in the momentum leads to the change in price.

This idea is highly reasonable if one were to observe what happens during a powerful directional move.

Think about it this way.

Suppose that market is in an uptrend.

Bulls have bid the price up, creating higher highs.

Usually the market will behave in the following matter:

First prices will break out as early buyers pile into the currency in anticipation of a rise.
Initially prices will break out as early bulls open long positions in anticipation of a rise.
Then more traders seeing the market rise will join the action hoping to extend the trend.
Additionally, bears who are now deep in loss territory would begin to sell realizing that they are on the wrong side of the trend.

This sequence of events would only propel prices higher and then the rest of the crowd will jump on the bandwagon, hoping that prices will continue their progression.

At that point most of the smart money who wanted to be long have already established their positions and the rate at which new highs appear slows.

The early bulls who have now acquired significant profits start to liquidate their positions seeing prices level off.

All of this translates into one simple fact - velocity has slowed.

It comes down to this.

Momentum will usually taper off before price will stop its progression and change direction.

Reading the MACD indicator

Since the MACD plots the difference between two moving averages, the idea is that if prices are rising, the short term moving average will increase at a faster rate than the long term moving average.

The moving average convergencedivergence therefore will slope upward.

The opposite dynamic will happen if prices are falling.

The moving average convergence-divergence is an unbounded indicator, but it does oscillate around zero with values becoming increasingly positive as prices rise and increasingly negative as they fall.

The MACD plots the difference between two moving averages instead of the moving averages themselves, and consequently it is far less affected by choppy markets as it filters out the noise.

The MACD is also plotted with its trigger line, which is simply the 9- period exponential moving average of the MACD itself.

Much like the moving average crossover, the trigger line signal is traded when the line crosses it from the upside or the downside.

The moving average convergence-divergence signals are always triggered later than the price action itself because MACD is generally slower.

These signals tend to be more precise than just moving average crossovers despite the fact that they are coming in later.

In 1986 Thomas Aspray invented the MACD histogram, improving on the original idea.

The histogram is a visual way of representing the difference between the moving average convergence-divergence and its trigger line.

It fluctuates around the zero line, where the trigger line and the MACD cross one another.

With rising prices the MACD will move away from its trigger line, as the MACD tends to increase at a faster rate.

It all comes down to this.

At its core, the moving average convergence-divergence histogram calculates the velocity of price movement, but its real value is in the fact that it is a very effective indicator of momentum, offering a very strong clue to future price direction.

The most common uses of MACD in trading include:

the MACD cross
the divergenc
the divergence with trendlines
as an overbought/oversold tool
the MACD “turn”
MACD’s peaks and troughs.

A more detailed breakdown of these strategies is presented below.

Trading the MACD cross

The most prevalent use of the moving average convergence divergence is as a trend indicator, and the most important signal is when the faster moving average breaks the slower one, indicating that a trend might be emerging in the same direction as the cross.

With that specific aim, one way to apply the MACD and signal lines as follows:

Buy when the moving average convergence divergence line (faster) crosses above the signal line (slower).
Sell when the moving average convergence divergence line crosses below the signal line.

Trading the divergence

Divergence is one of the fundamental ideas in technical analysis.

Its purpose is to signal ahead when prices are about to change direction.

To find divergence on the chart, follow these directions:

Locatehighestprice peaks on the chart.
Find two consecutive rising peaks.
Draw a line connecting them.
Observe the MACD line directly below the line drawn in the upper part of the chart. Find a peak in the MACD corresponding to a peak in prices. Connect the two peaks in the MACD line.
One line is drawn on a top of the price highs. The other is across the MACD peaks. We have a divergence whenever those two lines are angling in opposite directions.

Bearish divergence occurs when prices move higher and the MACD moves lower.

This divergence represents an important piece of data because the MACD is not confirming the bullish move, but indicating that the market has bearish bias.

Bullish divergence happens when the opposite occurs.

The market is dropping, but the moving average convergence divergence is rising as prices are about to change direction.

Divergence is one of the most useful of all indicators and as you look at it closer, you will see that the divergence is often created when the newer price peaks get farther and farther apart.

Divergence is most effective when it is unambiguous.

However if the price peaks are almost of the same height, and the MACD line is nearly horizontal, then the result of the divergence may be unclear.

Anticipating the divergence

Once you get better at recognizing a divergence, you’ll want to get in as early as possible.

Normally, we enter a bearish divergence after the second moving average convergence divergence peak is completed that is lower than the previous peak.

But here’s something really interesting.

We may be able do better.

When the market moves above the previous high we start looking closer at the MACD.

If the MACD value is less than the previous MACD high when the market breaks out to the upside, we will need to start selling now.

The following is one way of handling the anticipatory action.

Divide your funds into three parts:

Sell the first third when the market makes a new high and the MACD is much lower than previous peak.

Sell the second portion when the MACD line is within 20 % of the prior MACD peak.

Sell the third portion after the MACD line crosses the signal line on a way down.

Exiting a divergence trade

We can think of a bearish divergence as a special case of the overbought market.

It has reached new highs but slowed down and gives every sign of wanting to change direction.

Just like any other overbought situation, once the market has returned to a neutral state, the trade is over.

In case of divergence, that occurs when the moving average convergence divergence value reaches zero.

Despite the fact that divergence signal is dependable, it is not perfect.

If you are holding a short due to a bearish divergence and market starts to back up, but the MACD value rises above the previous MACD extreme, then the divergence is no longer valid.

Once the MACD peaks start rising, the trade must be exited.

Combining divergence with trendlines

One quite useful tactic is to combine trendlines with a divergence.

When using a trendline to open a position, watch for the completion of both bearish and bullish divergence patterns.

If you are holding a long position and a bearish divergence forms, then sell and monitor the trendlines closely to see if price breaks it.

Distance between MAs (overbought/oversold)

Since the moving average convergence divergence indicator has no limit, it can be successfully used as an overbought/oversold tool.

Let see exactly how this works:

To determine when the market has entered an overbought/oversold area, monitor the indicator for a sizable distance between the fast and slow lines of the MACD. The simplest way to see this divergence is by comparing the histogram heights.

This type of divergence frequently results in strong rallies counter to the dominant trend.

Trading the MACD “turn”

The moving average convergence divergence histogram is a very responsive measure of price velocity.

And here’s the interesting thing.

It is very effective in trading the MACD “turn”.

The moving average convergence divergence “turn” essentially triggers entries and exits based on the MACD histogram instead of the price itself.

Here’s how it goes:

A bearish signal is triggered when the MACD histogram creates a lower high, indicating that the momentum is subsiding.
A bullish signal is triggered when the MACD histogram prints a higher low, signaling an increase in momentum.

Using a bullish signal as an example, we would take a long position once the MACD histogram creates a higher low on one of its bars.

Oftentimes the market will continue to decline just as the moving average convergence divergence histogram creates even higher lows.

At this point an inexperienced trader might panic and make a critical mistake stopping themselves out, frequently just at absolute price lows.

Adhering to the logic of the setup is one of the key principles of trading with indicators.

What it means is this.

If the position was triggered due to an indicator signal, then the rule set for stop and exit must be based on the indicator as well.

Using the MACD turn as an example, the trade would be exited only if the moving average convergence divergence value created a new swing low.

Essentially, in the case of MACD turn we would be trading the indicator values instead of the price.

Many beginners would initiate a position based on an indicator signal but exit at some prearranged price, which falls short of the logic just like comparing apples vs. oranges, and will frequently fail as result.

It shouldn’t come as a surprise, then, that quite a few traders who experiment with indicators would prematurely give up in frustration and profess that technical trading “does not work.”

Which, in a way, certainly is correct because any set of tools applied incorrectly will fail at their intended purpose.

MACD’s peaks and troughs

The features of the histogram itself can be used for divergence analysis.

Additional useful information can be gained from monitoring and comparing the MACD peaks and troughs the with the price line in a divergence analysis.

Because the peaks and troughs in the histogram are sensitive to price directional change over short periods, they can also be used to indicate faster price trend changes within the slower trend.

Summary

The moving average convergence divergence histogram reacts faster to changes in price direction, while MACD itself lags a bit.

Therefore, if you wish to jump on any potential new trend ASAP, use the MACD Histogram.

Think of MACD as trend following approach – with all its strengths and weaknesses.

Don’t anticipate the most easy and obvious techniques to bring you great results by themselves.

Instead, try to combine the simple MACD crossover system with another idea.

For example, waiting for the first correction after a new trend have been identified using MACD, and then entering.

Or find ways to define sideways moving market and avoid taking MACD signals under those conditions.

Try It Yourself

After all the sides of the indicator were revealed, it is right the time for you to try either it will become your tool #1 for trading.

In order to try the indicator performance alone or in the combination with other ones, you can use Forex Tester with the historical data that comes along with the program.

Simply download Forex Tester for free. In addition, you will receive 22 years of free historical data (easily downloadable straight from the software).

We would love to hear about your experience using MACD indicator.

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