When it comes to building a trading strategy, finding the right tool to match your trading and investing goals is an arduous but necessary process. Formulating a consistently performing strategy requires a lot of backtesting and refining. One of the building blocks of trading strategies is finding a technical analysis indicator that could match your goal and trading style. One of the most popular indicators traders use is the Moving Average Convergence-Divergence or MACD.
What is MACD?
Moving Average Convergence-Divergence, or MACD, is a trading indicator developed by Gerald Appel in the late 1970s. It is a trend-following momentum indicator that allows traders to spot potential buy and sell signals using three main components:
MACD Line
The MACD line is the difference between two exponential moving averages, which is commonly using the 12-day EMA and the 26-day EMA. This line captures the asset’s short-term momentum or rate of change.
Signal Line
The Signal Line is a 9-day exponential moving average of the MACD Line. This trigger line provides potential buy and sell signals the moment it crosses the MACD Line.
Histogram
The Histogram shows the difference between the MACD Line and the Signal Line. It provides the trader with a visual representation of either the convergence or divergence between the two lines.
How to use the MACD?
MACD provides traders with different ways to improve their strategies. These strategies can are applied in the form of:
Trend reversals
Traders can use cross-over signals provided by the MACD and Signal to identify potential trend reversals. Bullish crossovers occur when the MACD Line crosses above the Signal Line, signaling a potential upward trend. Conversely, bearish crossovers indicate a potential downward trend.
Confirming trend strength
Besides crossovers, the slope and distance between the MACD Line and the Signal Line help indicate the strength of a trend. A widening gap suggests increasing momentum, while a narrowing gap may indicate a potential trend reversal or consolidation.
Spotting divergences
Divergences occur when the price of an asset moves in the opposite direction of the MACD indicator. Bullish divergences occur when the price makes lower lows while the MACD makes higher lows, signaling a potential trend reversal. Bearish divergences indicate the opposite.
Pros and cons of MACD
Any indicator will always have its own advantages and limitations, MACD will also have its own. What’s important is for traders and investors to leverage on its advantages and respect its limitations. Understanding these pros and cons is crucial for traders looking to maximize MACD effectively.
Advantages
Versatility
MACD can be used across different timeframes and instruments, as well as complement existing strategies of traders.
Clear signals
One of the things that make MACD powerful is that its crossover between the MACD Line and the Signal Line provides clear signals and allows traders to minimize subjectivity.
Confirmation with divergences
MACD’s ability to spot divergences gives traders an additional context and adds a layer of confirmation to trading decisions, especially in potential reversals.
Disadvantages
Lagging indicator
Due to MACD’s reliance on historical data and moving averages, it gives out a delayed set of signals, unlike some indicators.
False signals
Like any other indicator, MACD can also generate false signals. This is most prevalent in choppy or sideways markets.
No clear overbought and oversold conditions
Unlike the RSI, MACD does not revolve around a 0-100 line and provides traders with explicit overbought or oversold levels. Traders will have to use different indicators should they require this in their analysis.
Additional strategies for using MACD
With MACD’s basic uses, some would think that that is all there is to it on MACD. However, once traders look deeper into its application, they will find other advanced ways of using MACD:
Intraday entry and multiple time frame analysis
With MACD’s versatility, traders can use it across different periods to get a broader perspective on the trend or optimize entries on an existing trend. For example, if the MACD on a higher timeframe confirms the MACD on a lower timeframe, traders can get confirmation of the trend’s strength and set up buy entries.
Histogram Divergence
Besides regular divergences between the MACD Line and the price, traders can also analyze divergences between the price and its histogram to spot potential changes in the trend. This is a powerful technique for gaining insight into potential trend reversals or continuation.
MACD with other indicators
Even with MACD’s uses, it can be complemented by other technical indicators for different sets of trading applications. For example, a trader can use the MACD as a divergence and trend-confirming tool but bases his or her buy entries on moving averages, crossovers, price action, or a combination of other strategies.
Volume analysis and MACD strategy
Volume analysis can help provide additional confirmation on MACD signals. When volume increases during a MACD crossover, it helps validate the strength of the signal as it tells traders that new buyers are jumping into the trade to buy/sell the security and make a potential follow-through.
Final thoughts
The Moving Average Convergence-Divergence indicator is one of the most versatile indicators that traders have used for a long time. It has proven to help enhance a trader’s decision-making process with its mastery. With its ability to identify trend reversals, spot divergences, and confirm trend strength, it’s like a Swiss knife for technical analysis.
While it offers valuable insights into market dynamics, traders should always remember that, like any technical indicator, it still has advantages and disadvantages that need to be weighed. Having a firm understanding of how MACD works and setting realistic expectations can help lessen trading risks and increase profits and performance.
