What is MACD?
MACD is an acronym for Moving Average Convergence Divergence.
This technical indicator is a tool that’s used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish.After all, a top priority in trading is being able to find a trend, because that is where the most money is made.
With a MACD chart, you will usually see three numbers that are used for its settings.
- The first is the number of periods that are used to calculate the faster-moving average.
- The second is the number of periods that are used in the slower moving average.
- And the third is the number of bars that are used to calculate the moving average of the difference between the faster and slower moving averages.
- The 12 represents a moving average of the previous 12 bars.
- The 26 represents a moving average of the previous 26 bars.
- The 9 represents a moving average of the difference between the two moving averages above.
There is a common misconception when it comes to the lines of the MACD.
There are two lines:
- The “MACD Line“
- The “Signal Line“
The two lines that are drawn are NOT moving averages of the price.
The MACD Line is the difference (or distance) between two moving averages. These two moving averages are usually exponential moving averages (EMAs).
When looking at the indicator, the MACD Line is considered the “faster” moving average.
In our example above, the MACD Line is the difference between the 12 and 26-period moving averages.
The Signal Line is the moving average of the MACD Line.
When looking at the indicator, the Signal Line is considered the “slower” moving average.The slower moving average plots the average of the previous MACD Line. Once again, from our example above, this would be a 9-period moving average.
Most charts use a 9-period exponential moving average (EMA) by default.
This means that we are taking the average of the last 9 periods of the “faster” MACD Line and plotting it as our “slower” moving average.
The purpose of the Signal Line is to smooth out the sensitivity of the MACD Line.
The Histogram simply plots the difference between the MACD Line and Signal Line.
It is a graphical representation of the distance between the two lines.
It may sometimes give you an early sign that a crossover is about to happen.
If you look at our original chart, you can see that, as the two moving averages (MACD Line and Signal Line) separate, the histogram gets bigger.
This is called a MACD divergence because the faster moving average (MACD Line) is “diverging” or moving away from the slower moving average (Signal Line).
As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average (MACD Line) is “converging” or getting closer to the slower moving average (Signal Line).
And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!
Ok, so now you know what MACD does. Now we’ll show you what MACD can do for YOU.
How to Trade Using MACD
Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.
When a new trend occurs, the faster line (MACD Line) will react first and eventually cross the slower line (Signal Line).
When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed UNDER the slow line and correctly identified a new downtrend.Notice that when the lines crossed, the Histogram temporarily disappears.
This is because the difference between the lines at the time of the cross is 0.
As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is a good indication of a strong trend.
Let’s take a look at an example.
In EUR/USD’s 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend could potentially reverse.From then, EUR/USD began shooting up as it started a new uptrend. Imagine if you went long after the crossover, you would’ve gained almost 200 pips!
There is one drawback to MACD.
Naturally, moving averages tend to LAG behind price.
After all, it’s just an average of historical prices.
Remember, the MACD indicator consists of three components:
- The MACD Line which represents the difference between two moving averages.
- The Signal Line which is a moving average of the MACD Line.
- The Histogram which is a graphical representation of the distance between the MACD Line and Signal Line.
That said, MACD is still one of the most favored tools by many traders.