MACD stands for moving average convergence divergence, and as its name implies it is used to identify a new trend. So, it is actually a trend-following indicator that is used by traders extensively in their trades. It was developed by Gerald Appel in 1979 and works with the same efficiency in each type of markets like forex, commodity, and options.
It operates based on the movement of two moving average lines w.r.t each other. It shows whether these two lines are converging i.e coming closer or deviating from each other. These two lines move freely upside down w.r.t. each other based on the difference in the value of moving averages.
Moving Average Convergence Divergence(MACD) is a powerful weapon in the hands of a trader to improve the accuracy of trading. “MACD” is also known as “MAC–DEE” in the trader fraternity sometimes and it produces an indicative result by refining two moving averages and you can calculate it by measuring the distance between two lines.
The MACD indicator is built on this very concept and it is a widely used tool in the technical analysis of stocks in the stock market by traders.
What is MACD Indicator
It is one of the most widely used technical indicators by traders across the world and it helps a trader identify changes in the strength, momentum, and direction of the trend of the stock market. It is a trend-following momentum indicator which means it follows the trend and indicates the best entry and exit signals for a trader.
Components of MACD
MACD Indicator is made up of mainly four components which you must know before using this indicator in your trading.
MACD Line Fast Line
It is a solid line that represents the difference between 12 days EMA and 26 days EMA of the stock closing price where EMA stands for Exponential Moving Average.
MACD Signal Line
This line represents the 9 days EMA of the fast line and it acts as a slow line as compared to another line of the indicator. It helps a trader to enter or exit the trade by indicating signals with the help of crossover.
Zero or Centre line
This line is marked at the value of zero and it has great significance in the MACD Indicator. If lines are above the zero line, it is taken as an indication of a bullish trend and it is the opposite for a bearish trend i.e both fast and signal lines will be below the zero line.
The indicator has Histogram which oscillates around the center or zero line with bars varying in size. The height of the bar depends on the difference between MACD Fast line and the Signal line. Also, the color of the bars keeps changing and bars are erected above or below the zero line based on this difference only. That means if the value of the fast line is more than the signal line, the fast line will be above to signal line, and hence the corresponding Histogram bar will be of green color and that bar will form above the zero line.
If the values of the signal line are more as compared to the fast line then the corresponding histogram bar will be of red color and will form below the zero line. Here the default values used in the calculation are 12 and 26 days of data for making the Fast line and 9 days of data for the signal line. But these values can be changed by the trader as per his strategies but default values are considered best base on the accuracy of results in trading.
How to identify convergence and divergence in MACD indicator
Convergence and Divergence of the two main lines i.e. fast line and the signal line will be shown on the MACD Histogram through the Histogram bars. The length of the Histogram bar will increase when both lines move away from each other while the length of the bars will decrease when both lines move close to each other. That means high volatility in the price will be depicted by the lengthy bars while a short bar means less movement in price.
When the difference between the fast and signal line becomes zero i.e. both lines meet up, then the corresponding Histogram bar will have a 0 value because both lines are equal. If the MACD line is above the signal line it indicates a Bullish trend and if the MACD line is below the signal line then it indicates a Bearish trend.
How does MACD Indicator work
The MACD Indicator acts as an oscillator because both the lines oscillate around the center of the zero line. Accordingly, the value of the indicator is considered positive and negative based on the crossovers of both lines. If the MACD fast line crosses the Signal line from below to the upper side, it is considered a Bullish crossover. While if the Signal line crosses the fast line from below to the upper side, it is considered a Bearish crossover.
The center or zero line has great significance in terms of crossover for trading and you should know about it. If the value of MACD is positive that means the 12 days EMA line has crossed the 26 days EMA from below.
Bullish Crossover of MACD
When the crossover of both lines happens, the place of crossover really does matter. If the Bullish crossover (Fast line crosses the signal line to the upper side) is happening below the zero line it is called a negative Bullish crossover while if this crossover is above the Zero line it is a Positive Bullish crossover.
Bearish Crossover of MACD
If the Bearish crossover (Fast line crosses the signal line to the lower side) is happening above the zero line it is called a negative Bearish crossover while if this crossover is below the Zero line it is a Positive Bearish crossover.
How to trade using MACD
Trading with the help of the MACD indicator has various strategies but the most common is based on the crossovers of two lines. A bullish crossover with an increasing difference among lines is taken as a strengthening of the bullish trend while a Bearish crossover with an increasing difference among lines is taken as a strengthening of the Bearish trend.
The BUY signal is triggered when there is a Bullish crossover and the SELL signal is taken into consideration when there is a Bearish crossover between two lines. So, you can decide your entry and exit time in the market by seeing these crossovers, but you should not forget to use stop loss in your trade at any cost. Positive crossovers have less probability to happen as compared to simple crossovers, but most successful traders suggest trading after the happening of a positive crossover only. But trading in the positive crossovers will have a less Risk Reward Ratio for a trader.
Whenever a Bullish crossover happens, the Histogram bar of green color starts building up, whose length depends on the difference between the fast line and the signal line. If the length of green bars is increasing, that means Bulls are dominating the market and it indicates the ‘Buy’ signal. On the other side, whenever a Bearish crossover happens, the Histogram bar of Red color starts building up. If the length of the Red bars is increasing, that means Bears are dominating the market and It indicates the ‘Sell’ signal.
Things to keep in mind while trading using MACD crossover
The first and foremost thing that, you must be confident about is the crossover happening. That means crossover must have a greater angle between two lines and it should not be too close to the zero line. If the crossover is happening with a small angle between two lines and too close to zero, there are higher possibilities that MACD can give false signals. For a beginner in trading, it is highly recommended to trade with only Positive crossovers, where the strength of the trend is obvious although your Risk Reward Ratio will be less. Also, you must not forget to place a stop loss in your trade to minimize the losses in trading.
We should trade with the trend only and when there is a Bullish trend, then only we should enter into the trade for BUY. If there is a positive bullish crossover of MACD, we should enter the trade and exit only if MACD indicates any change in the trend by giving any Bearish crossover. The same thing goes while you are entering into the trade in a Bearish trend. By trading in this way, although your Risk Reward Ratio will be less as a beginner it is the best and safest strategy.
You may also find it Useful
MACD is a popular trading tool used by traders in assessing the market scenario and accordingly taking the trade. But the MACD indicator is not used standalone for the purpose and some more technical indicators like Relative Strength Index and Moving Averages can be used with MACD to improve efficiency.