What is the MACD indicator in trading and how to read/use it?
What is the Moving Average Convergence Divergence (MACD) indicator?
The Moving Average Convergence Divergence (MACD) indicator is a momentum-based oscillator used by traders in their technical analysis. The indicator uses the strength of the trend to identify potential entry and exit points for trades. The MACD can help reveal whether a trend is gaining or losing strength, as well as help estimate how long it will stay intact before the price of the asset changes direction.
The MACD indicator consists of four key components:
- The MACD line (often displayed in blue), which is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA. The MACD line is positive (above zero) if the 12 EMA is above the 26 EMA and negative (below zero) if the 12 EMA is below the 26 EMA.
- The Signal line (often displayed in red/orange), which is the 9-period EMA of the MACD line.
- The MACD Histogram, which represents the difference between the MACD and Signal line.
- The Zero line is the midpoint of the MACD indicator.
MACD Histogram
When price is in a strong trend, the distance between the MACD line and the Signal line increases, resulting in the Histogram expanding, indicating growing momentum. As the trend gets weaker, the histogram starts to shrink. If the MACD crosses above the Signal line, the histogram turns green (indicating bullish momentum). If the MACD crosses below the Signal line, the histogram turns red (indicating bearish momentum).
Traders also analyse the slope of the histogram to gauge the strength of a trend. A steep slope signifies strong momentum, while a flattening or reversing slope signals weakening momentum. Furthermore, histogram contraction before a crossover can indicate losing momentum and a potential trend reversal.
The MACD indicator and its main components:
How is the MACD indicator calculated?
The MACD indicator is a representation of a collection of calculations.
- The MACD line is calculated by subtracting the (slower) 26-period EMA from the (faster) 12-period EMA.
- Next, we calculate the 9-period EMA of the MACD line to create the Signal line.
- Finally, the difference between the MACD line and the signal line is plotted as a histogram.
MACD formula
- MACD Line: 12-period EMA - 26-period EMA
- Signal Line: 9-period EMA of the MACD Line
- MACD Histogram: MACD Line - Signal Line
How to read the MACD indicator
To read the MACD, traders look at how the parts interact. When the MACD line crosses over the Signal line, that's a bullish sign — momentum's picking up. If it crosses under, it's bearish, meaning momentum's dropping. The histogram shows this visually: green bars above the zero line for bullish, red bars below for bearish.
The histogram's slope also tells you about the trend's strength. As a trend gets stronger, the MACD and Signal lines spread apart, and the histogram bars grow. Bigger bars mean stronger momentum.
Traders also filter false MACD signals by confirming trend direction on a higher timeframe. A MACD signal on a smaller timeframe, such as a 15-minute chart, is strengthened when it aligns with the trend on a higher timeframe, such as a 4-hour chart. Additionally, volume indicators like On-Balance Volume (OBV) can confirm momentum strength.
How to use the MACD indicator when trading
Traders use the MACD to identify trade entries and exits that align with the prevailing trend. A buy signal is generated when the MACD line crosses above the Signal line and the histogram is expanding, and a sell signal when the MACD line crosses below the Signal line and the histogram is contracting. When the histogram contracts, it reflects diminishing momentum, suggesting a possible trend reversal or a shift to a range-bound market, leading traders to seek exits.
To manage risk effectively, traders should use stop-loss placements based on key technical levels. For example, it could be below the recent swing low or 200 EMA for long trades and above it for short trades. When trading divergences, it should be beyond the last price extreme.
To prevent premature exits in trading divergences, a stop-loss placed beyond the last price extreme can prevent premature exits.
MACD Divergence
Traders also use MACD divergence to anticipate potential trend reversals. The divergence arises when the price action of an asset and the MACD indicator move in opposing directions. For example, the price might be hitting new highs or lows, but the MACD indicator is not confirming those movements, signalling instead a weakening of the prevailing trend.
The discrepancy between price and momentum can be bullish or bearish. Bullish divergence occurs when the price forms lower lows while the MACD creates higher lows. This signals that, despite the price decline, selling momentum is weakening, suggesting a potential upward reversal. Conversely, bearish divergence occurs when the price forms higher highs while the MACD makes lower highs, indicating that buying momentum is fading, which could lead to a downward trend reversal.
In ranging markets, MACD divergence signals are prone to false breakouts. To enhance accuracy, traders should validate divergence signals with established support and resistance levels or complementary indicators like Bollinger Bands.
How to use the MACD divergence when trading
Traders use MACD divergences to capitalise on potential trend reversals. A common strategy involves first identifying strong support or resistance levels on a higher timeframe. Once a key level is established, traders wait for the MACD to show divergence at that level. To confirm the trade entry, they then observe the Histogram for a decisive break of a key level, signalling the impending reversal.
Another effective strategy involves Bollinger Bands. When the price action moves outside the boundaries of the Bollinger Bands, traders look for a coinciding MACD divergence. This divergence validates the potential reversal setup. The entry is then triggered when the price closes back within the Bollinger Bands, indicating a likely continuation of the reversal.
In both cases, it is crucial to trade clear and unambiguous divergences, reducing the risk of false signals.
MACD Crossover
The MACD crossover occurs when the MACD line intersects the Signal line, signalling a potential buy or sell opportunity.
It is a fundamental component of many trading strategies, offering a potential advantage over traditional Moving Average (MA) crossovers. The MAs tend to follow price changes later than the MACD crossover, but the MACD crossover shows possible reversals earlier. This lets traders get better entries, use tighter stop-losses, and catch more of a price swing.
1. MACD Line & Signal Line Crossovers
These provide direct signals of potential price direction. A bullish crossover, where the MACD line crosses above the Signal line, suggests a buy signal, while a bearish crossover, where the MACD line falls below the Signal line, indicates a sell signal. While offering earlier signals than simple MA, these crossovers are more prone to generating false signals.
2. Zero Line Crossovers
Zero Line crossovers strengthen MACD signals by focusing on the MACD line's movement above or below the zero line, indicating a shift in momentum. In general, these crossovers don't give off as many false signals. They work best when used with tools that confirm trends, like Exponential Moving Averages (EMAs) or price action analysis. To enhance their accuracy, traders often integrate Zero Line crossovers with other indicators, including support and resistance levels, EMA bands, or trendlines.
How to use the MACD crossover when trading
Traders use crossovers for early reversal signals to identify faster entry points than those provided by traditional moving average strategies. This enables potentially better entries with tighter stop-loss orders – and more effective risk management.
Another approach used in trending markets employs zero-line pullback continuations. Traders seek a confirmation of the prevailing trend by observing price pullbacks to EMA bands, coupled with the MACD line touching or briefly crossing the zero line. This confluence strengthens the signal, indicating a potential resumption of the trend.
Finally, crossovers confirm entries at swap zones, where previous support or resistance levels have reversed roles. Traders await a retest of the swapped level and use a MACD crossover to validate price action, filtering out false breakouts.
Advantages and disadvantages of MACD
Advantages
The MACD offers traders a valuable combination of features. It effectively identifies both trend direction and momentum, offering a comprehensive view. Because it is straightforward to interpret, it is accessible for traders across various experience levels. It is adaptable to different timeframes and markets.
Disadvantages
Like all indicators, the MACD can generate false signals, especially in volatile or range-bound markets with erratic price action. As a lagging indicator based on past prices, the MACD can result in late entries in fast-moving markets. Furthermore, the interpretation of MACD signals, particularly divergences, can be somewhat subjective, leading to confusion among traders.
Therefore, it's essential to use the MACD in conjunction with other analysis tools and to exercise caution, especially in less predictable market conditions.
MACD advantages |
MACD disadvantages |
|
Identifies trends and momentum early |
Generates false signals in ranging markets |
|
Faster than traditional moving averages |
Lags compared to real-time price action |
|
Works well with other indicators (EMA, Bollinger Bands, S/R) |
Divergences don’t always lead to reversals |
|
Can be used for both trend-following and reversal trades |
No built-in stop-loss or risk management |
|
Easy-to-read histogram for visual confirmation |
MACD crossovers give late signals in pullback trades |
Conclusion
The MACD is a powerful tool for technical analysis, offering valuable insights into trend direction and momentum. While it has limitations, traders can maximise its accuracy by combining it with additional indicators, higher timeframe confirmations, and proper risk management strategies.
Ready to trade your edge?
Join thousands of traders and trade CFDs on forex, shares, indices, and commodities!
This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation and needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability with regard to the accuracy and completeness of the content in this publication. Readers should seek their own advice.
FAQ
How can traders improve MACD accuracy?
Traders can improve MACD accuracy by using higher timeframe trends to confirm signals, using volume indicators like On-Balance Volume or the Relative Strength Index to validate momentum strength, and combining MACD signals with established support and resistance levels to increase the probability of successful trades.
Why do MACD divergences sometimes fail?
MACD divergences can sometimes fail due to temporary pullbacks within an existing trend. To avoid misleading traders, it's crucial to prioritise clear and unambiguous divergences and confirm divergence signals with other technical indicators before executing trades.
Can MACD crossovers lead to late entries, and how can I address this?
MACD crossovers can sometimes result in late entries in fast-moving markets due to the traditional 12- and 26-period EMA settings lagging behind price movements. To counter this, traders can use shorter EMA settings like 8-period and 21-period EMA, which provide faster signals and allow earlier entries in volatile markets but may increase false signal frequency.
