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Understanding MACD for Traders

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19 views7 pages

Understanding MACD for Traders

Uploaded by

Sunil Jadhav
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Introduction to MACD

By Kristina Zurla Landgraf • Feb 2nd, 2010 • Category: Book Reviews, Broker Commentary, Educational, Lind-
Waldock In the News, The Lighter Side

by Dennis Cajigas

Moving Average Convergence/Divergence, otherwise known as MACD, was created by Gerald


Appel in the 1960s as a way to analyze market momentum and strength. While it fell out of favor
in the early 1980s, it experienced a resurgence of popularity with the development of the MACD
histogram by Thomas Aspey in 1986. The histogram provided a way to anticipate crossovers in
the MACD, providing another method of analysis that gave the MACD a renewed sense of
relevance. Traders often use the histogram as a tool to anticipate trend and momentum shifts.

One of the most useful things about the MACD is that it allows traders the ability to identify
market trend changes and strength of momentum in a single indicator. It is particularly popular
among currency traders.

The MACD represents the difference between two (fast and slow) weighted moving averages of
closing prices. The 12-day moving average is commonly used to represent the fast, while the 26-
day moving average, the slow. A trigger line, or signal line, is created by smoothing the result
with another weighted moving average. Most commonly, the 9-day is used. This creates a
centered momentum oscillator, which visually indicates shifts in trend or changes in momentum.

Common Pitfalls
The MACD is a powerful and useful indicator, but it is a lagging indicator. Often there may be a
delay between a signal in the MACD and price movement. The MACD may be used in all
market condition types, but it is most useful in volatile markets when trend changes more
frequently.

Traders should be careful not to mix signals when forming their trade strategies. For example,
when entering a momentum-based trade, the exit strategy should be on a momentum indicator
rather than a price, time or profit target.

Four Types of Signals

1. Moving Average Crossover. This occurs when the two moving averages (fast and slow) cross.
It indicates a potential shift in trend; essentially more buying (or selling) is coming into the
market. It is the most common type of signal, but should be reinforced with another type of
signal as it can occur fairly often. A three-bar confirmation in the price action or in the MACD
histogram can provide a confirmation signal.

In the chart examples that follow, you’ll see two red and blue lines at the bottom, representing
the two moving average time periods (fast and slow). The histogram in the middle has a line
running through the center, which creates a trigger or signal line.
The histogram visually shows the difference between the moving averages. It also smoothes out
fluctuations. I’m using a candlestick chart, with down days designated by red candles and up
days by green.

Let’s look at a daily chart of the U.S. dollar in 2009 as an example. In the lower part of the
screen, there is a moving average crossover of the12-day and 26-day moving averages,
represented by the tan circle. We see the shift in price reflected in the corresponding tan circle in
the candlestick chart, as the market starts to decline. There is another crossover as the trend shifts
to the positive side in the next set of light blue circles farther to the right of the chart, as buying
comes into the market. You see the reflection of the price move in the MACD, and we have
continued rallies going forward.

Chart 1, Moving Average Crossover

2. Centerline Crossover. This occurs when the MACD moves past the zero line and moves into
the opposite territory. That is, going from positive to negative, or negative to positive. It can be
combined with other types of indicators to confirm the signal. Traders will often also monitor the
slope of the histogram or the two indicator lines to reveal increasing strength or weakness of the
market momentum. How quickly is it moving, and how fast and strong?

In the next chart, we see the centerline crossover and the shift from negative to positive. The bars
are steadily and slowly increasing, which shows more buying coming in, and increased positive
momentum (represented by the beige ellipses). Notice the extreme slope on the histogram and
the corresponding gaps in price action on the chart. A bit of a bullish pennant formation is seen
in the price chart.

The purple bars (histograms) move below the zero line and then above as price rises (tan circles).
We then see a negative crossover to the right on the chart. As the length of the histogram
increases, the slope increases and we see that in bearish price action (indicated by the light blue
circles).

3. Positive/Negative Divergence. This occurs when the strength or weakness of the MACD
differs from the relative price action of the market. It is the least common of all the MACD
signals, but is often the most reliable of the MACD signals, indicating a major trend shift.

On Chart 3, we see a high occur, and then a lower high on the MACD histogram, indicating
weakening or exhausting buying pressure. The MACD is telling us the rally we are seeing is a
weak one (see the orange line at top right). Afterward, we see a drop in price reinforced by the
drop in the MACD and MACD histogram. The market’s bottom should be indicated by a drop in
momentum.

Chart 3, Positive/Negative Divergence


4. Multiple Indicator Signal. If you have one indicator producing a signal, you might want to
reinforce it. As the MACD crossover goes from bearish to bullish in Chart 4, it is reinforced later
by a centerline crossover. We thus have two signals combining to reinforce the trade. We see an
increasing histogram, indicating increasing bullish momentum entering into the market, and
price action confirms the bullish shift. Within the light blue ellipses, we see multiple indicators.
The MACD crossover gives indications of a possible shift, and the centerline crossover indicates
increasing momentum.

Chart 4, Multiple Indicator Signal


Looking at a more current chart of the U.S. dollar in early 2010, the blue ellipse represents a
positive (bullish) moving average crossover and it is reinforced by a positive centerline
crossover. These bullish MACD signals are reflecting the shift in price action and you can see
market trend change indicated by the blue ellipse on the price chart.

The beige rectangle is overlain on another positive moving average crossover and the MACD
signaled a momentum shift within an already established trend. The MACD signal indicated a
rally extension (micro-trend change) as opposed to a major trend shift.

U.S. Dollar Index, Early 2010


This is just a brief introduction to MACD, and I encourage you to do further research and to
contact me with questions on how you might apply these techniques to your market analysis. I
find the MACD to be useful for all markets to determine momentum and trend shifts.

Dennis G. Cajigas is a Senior Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted
division. He can be reached at (866) 631-6216 or by email at dcajigas@[Link].

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based
on information taken from trade and statistical services and other sources which Lind-Waldock
believes are reliable. We do not guarantee that such information is accurate or complete and it
should not be relied upon as such. Trading advice reflects our good faith judgment at a specific
time and is subject to change without notice. There is no guarantee that the advice we give will
result in profitable trades. All trading decisions will be made by the account holder.
© 2010 MF Global Holdings Ltd. All Rights Reserved.

Common questions

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Combining signals in a 'Multiple Indicator Signal,' such as a MACD crossover confirmed by a positive centerline crossover, reinforces the validity of potential trend and momentum shifts. This approach provides multiple confirmations of market conditions, thereby increasing the trader's confidence in trade decisions and reducing reliance on any single indicator's accuracy .

Traders find MACD more beneficial in volatile markets because its lagging nature is less of a hindrance in environments where trend changes are frequent. In stable markets, the lag can result in traders missing optimal entry or exit points, whereas in volatile markets, MACD's ability to indicate momentum and trend shifts becomes more advantageous for capturing potential gains .

The MACD's nature as a lagging indicator means there may be delays between an MACD signal and actual price movement. This characteristic makes MACD more useful in volatile markets with frequent trend changes, as it may be less effective for making timely trades in stable markets. Traders must be cautious of this lag when forming strategies and should complement MACD signals with other indicators .

The slope of the MACD histogram helps indicate the acceleration or deceleration of market momentum. A steep slope can signify a strong shift in buyer or seller momentum, thereby predicting an increase in market movement strength, whereas a flattening slope might signal a potential decrease in momentum and a forthcoming trend exhaustion or reversal .

The MACD centerline crossover occurs when the MACD line crosses the zero line, indicating a shift from positive to negative momentum or vice versa. This helps traders identify changes in market strength and potential trend reversals. Traders often combine this signal with the slope of the MACD histogram or two indicator lines to gauge the momentum's strength and direction, enhancing the robustness of their analysis .

A 'Moving Average Crossover' occurs when the fast and slow moving averages cross each other, indicating a potential shift in market trend due to changes in buying or selling pressure. Although it is a common signal, it is advised to confirm this with additional indicators since such crossovers happen often. Confirmations might include looking for a three-bar confirmation pattern in price action or the MACD histogram itself .

Thomas Aspey developed the MACD histogram in 1986, which provided a way to anticipate crossovers in the MACD. This development allowed traders to have another method of analysis that renewed MACD's relevance by visually representing changes in market momentum and helping to predict trend shifts more effectively .

Traders should align exit strategies with momentum indicators in momentum-based trades to avoid discrepancies between exiting on momentum versus static targets like price or time. This alignment ensures the exit strategy reflects actual market movement, enhancing the chances of capturing the most favorable market conditions and preventing premature exits that may occur with static targets .

Combining multiple MACD indicators, such as a bullish crossover with a positive centerline crossover, enhances the robustness of a trading strategy by providing reinforcement through confirming signals. These combined signals suggest a stronger momentum shift than a single indicator alone and help traders identify more reliable entry and exit points in the market .

Divergence between MACD movement and actual market price action—known as positive or negative divergence—signals potential major trend shifts. It is a less common but highly reliable MACD signal because it often indicates underlying strengths or weaknesses not immediately apparent in price movements. This can foreshadow upcoming reversals, making it valuable for traders seeking to anticipate major trend changes .

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