The pitfall of most new traders is focusing solely on support and resistance levels as points of entries and exits without understanding the momentum behind the move that pushes price to those liquidity areas. That gut feeling is all too often a decision to regret when price action unexpectedly moves in perplexing ways against your trade. In our past blog posts, we have looked at a few indicators which help to better understand the price moving force of momentum. In this blog post, we would like to look at one of the most popular momentum / price trend indicators; The MACD Indicator.
What is the MACD Indicator?
MACD stands for “Moving Average Convergence Divergence”. As a momentum oscillator that follows the price trend relationship of two moving averages of an asset, which is derived by subtracting the 26 day EMA from the 12 day EMA. This results in a 9 day EMA which is known as the “signal line” and the main part of the MACD. The MACD Indicator is comprised of 4 components:
- The Signal Line: As mentioned above, a yellow line which represents the 9 day EMA.
- The MACD Line: Which is the 12 day EMA represented by a blue line.
- The Histogram: The series of vertical lines which represent the distance between the “signal line” and the “MACD line”. Blue bars above the “zero line” indicate positive momentum; the red lines, negative.
- The Zero Line: The horizontal line which separates the positive and negative territories of the histogram.
On the chart, the “signal” and “MACD” lines oscillate in line with the current price trend / momentum and illustrate the distance between the 9 and 12 day EMA respectively. The distance between these two lines (also represented in the length of the bars on the histogram) may be a sign into the strength of the reversal when the MACD signal prints on the chart. The MACD signal is when the “signal line” (yellow) crosses over or under the “MACD line” (blue). A cross from below is bullish momentum; one from above the line is bearish. This is also reflected in the histograms with the bars flipping into either the negative or positive territory along the “zero line” and growing in length to reflect the gaps between the two lines. So what does this all mean? Let’s look at how to trade the MACD Indicator.
Trading with the MACD Indicator
The most common use of the MACD Indicator is to trade a part of its namesake; divergences. The MACD divergence is when the momentum of the indicator contradicts the movement in price which points to potential reveals in trend. Having prior knowledge of these pending trend reversals is how the market insiders stay ahead, making the MACD indicator an extremely useful tool for the retail trader. There is so much going on behind the scenes in the market which we can never know, but MACD divergences provide insights into the buying and selling patterns of institutions (and overall market sentiments) that can alert us to pending price moves for profitable trades.
Bullish Divergence (as seen below) is when the price is making lower lows and the MACD Indicator makes higher lows; plotted from the underside of price and MACD; as seen below.
Bearish Divergence is the inverse of bullish divergence with the price making higher highs with the MACD printing lower highs; plotted from the topside of price and the MACD Indicator, as seen above.
MACD Indicator Crosses
Crosses of the “MACD” and “signal” line result in what are known as “golden” (bullish – seen above) and “death” (bearish – seen below) Crosses. A “golden cross” is when the short term 9 day EMA (signal line) crosses above the 12 day EMA (MACD line). The “death cross” is the inverse crossing of the signal line below the 12 day EMA (MACD line). These crosses are often used to confirm trend reversals. However, we strongly recommend that they are used with other indicators for confirmation. As the MACD is a lagging indicator of short term moving averages, it does occasionally result in false positives. To mitigate this, the MACD indicator on TrendSpider can be adjusted to the 50/200 EMA (or any of your choice) to filter out some of the noise. Prior to the crossing of the lines, the histogram is a good reference to assess the validity of the cross. By looking at the slope of the histogram bars into the “zero line”, one can gauge the momentum into the cross for potential continuation.
Golden (Bullish) Cross
Death (Bearish) Cross
Thoughts Before Trading with the MACD Indicator
Divergence trades are not without a margin of error which should be respected. The price very often has a few final surges up / down before following through with the indicators momentum signal. This is how many positions get “stopped out” before the move the entry was based on actually happens.
One other point to consider before entering a trade on a MACD signal, is to not enter on a MACD signal; as the MACD is a derivative of price and NOT price itself. Therefore, the price reflected in the cross/divergence is not actually the price on the chart. To avoid this discrepancy when entering and exiting a trade, it might be a good idea to refer to the histogram for both trade entries and exits. For example, if taking a short trade, scale in a portion of the total trade amount at the initial point of divergence on the histogram and set a stop at the nearest swing high on the chart. This way the trade is “stopped out” only if the MACD Indicator histogram gains the previous swing high, confirming that momentum is actually increasing in the opposite direction of the trade. If he MACD doesn’t achieve a new high on the histogram, then adding to the position might be reasonable (as seen in the example below).
All too often we must remind ourselves that there is no “silver bullet” when it comes to predicting price momentum. Nevertheless, with a proper understanding of how to use the many indicators available on TrendSpider, traders can increase the probability outcomes towards more profitable trades. On TrendSpider, you can set Multi Factor Alerts on the MACD Indicator to help you fine tune your entries and exits when trading the MACD Indicator with an alert delivery directly to you via email / SMS.