A brief description of the MACD indicator
The MACD indicator is a phrase that stands for the Moving Average Convergence Divergence indicator and is made up of three main components – a faster moving average line, a slower moving average line and a histogram.
However, it is important to note that the moving averages that make up the MACD indicator are not the moving averages of an asset’s actual price, but are averages of other moving averages.
Figure 1: A chart showing the MACD indicator
There are usually three figures that are displayed on the MACD chart with (12, 26, 9) being the default setting on most charts.
This means that the faster moving average is calculated as the difference between the 12-period and 26-period moving average of price to determine the figures of the faster MA line.
The slower moving average is calculated as the average of the last nine periods (bars) of the faster moving average.
Lastly, the histogram bars are plotted from the difference between the fast-moving and the slow moving averages.
How to use the MACD indicator
The MACD indicator is mostly used to determine if an existing trend is about to change when the moving average lines cross over each other.
Whenever the fast-moving MA (MACD line) crosses above the slow-moving MA line (signal line), also known as a bullish crossover, this typically indicates that a bullish trend is about to start.
The opposite is true whenever the fast-moving MA line crosses below the slow-moving MA line as this shows that a bearish trend is likely to get underway
Fig 2: A chart showing the fast and slow moving averages
Always remember that the MACD is a lagging indicator given that the MA lines that it is made up of are averages of other moving averages, which means that the MACD crossover will identify trends a bit later than when they began in many cases.
Why the MACD indicator can help you catch big trends
Identifying trends from the moving average crossover is a time-tested strategy that has been used by some of the greatest traders on the planet simply because it is known to work quite well.
For example, many trend traders use the 20-period MA to determine whether an asset’s current price trajectory is bullish or bearish. Equally, many stock traders use the 20-month moving average to determine whether the broad stock market is in a bullish or bearish trend.
The simplest way to use the MACD indicator is to enter into long trades once the fast-moving MA line crosses above the slow-moving (9-period) MA line. The opposite trade also works as one can enter into short trades when the fast-moving MA line crosses below the slow-moving MA line.
How to profitably trade MACD divergence
Most traders use the MACD as a contrary indicator to determine when a trend is over-extended and is about to reverse in order to catch the highs and lows of a particular asset’s prices.
This trading style is known as reversal trading where traders bet that an asset is too oversold or overbought and is therefore about to head in the opposite direction.
Reversal traders usually look for price setups where an asset is making higher highs, while the MACD indicator is heading lower, which usually happens at the top of a bullish trend and indicates that the bullish momentum is dying.
The opposite is true for setups where an asset’s price is making lower lows, but the MACD indicator is heading higher indicating that the bears are getting exhausted and the bulls are ready to take over and push prices higher.
When trading price reversals, be careful not to be overly exposed to the current trend by taking small trades until you are sure that the price has reversed and is now trending in your chosen direction.
How to minimise your losses using the MACD histogram
Given that most traders use the MACD indicator to place reversal trades, many novice traders incur massive losses when a trade keeps moving into overbought or oversold territory before reversing as this causes them to close their trades prematurely.
However, one of the best ways to avoid unnecessary losses is to monitor the MACD histogram and to only exit loss-making trades when a higher histogram than the one on which you took your trade is plotted, which means that the current trend is not about to reverse and you should cut your losses.