One of the first indicators I ever experimented with was the Moving Average Convergence and Divergence (MACD) indicator.
It was used on a higher time frame to identify the direction to trade on the lower time frame.
Depending on the condition of the indicator, I would also use it to objectively decide if a market was in a state conducive to good trading.
I still use it today however I use a modified version of the standard out of the box settings.
Let’s look at the makeup of this trading indicator and see what makes it tick. Perhaps you will find a use for MACD in your own trading toolbox after you do the proper back testing of the effectiveness.
What Is The MACD Indicator
The MACD indicator is considered, in a broad sense, a momentum indicator and to be more specific, it measures the change in momentum.
There are four parts to the MACD:
- Fast Line (moving average)
- Slow Line (moving average)
- Zero Line
- Histogram (not shown)
The fast line is simply is the value of the slow line (set at 26) subtracted from the value of the fast line (set at 12). The standard setting of the MACD is 12,26,9.
There are three important MACD features I want you to note and have plotted two exponential moving averages, the 12,26 to highlight them
A. Notice the difference between the two moving averages on price and the difference between the red fast line and the zero line (3). This indicates quite a bit of momentum at that current time.
B. The moving averages on price are relatively tight and the fast line on the MACD is almost hugging the zero line. This indicates a period of lower momentum.
C. Notice the red fast line crossing over the zero line and at the same time, the moving averages on price are crossing.
While we may say the fast line represents momentum the fact is that is measures the rate of change in price…the change in momentum.
The MACD Slow Line – Signal Line
The slow line (#2) is often called the signal line and with our settings, it is the 9 period moving average of the fast line.
This is used by many for trend determination by comparing the position of the slow line to the fast line. If the fast line is over the slow line, the trend would be considered up. The opposite is true for the reverse.
You can see the uptrend starting on the left had the fast line crossing the slow line to the upside (also note the moving average cross). Price rolls over, as does the red line, as it goes below the signal line.
Another change in trend takes place and then something interesting happens.
Note the rectangle and look at the lines on the MACD and the state of the price bars. I often used those MACD conditions to seek out another market or a different time frame.
How To Use The MACD Indicator
There are a few ways you can use the Moving Average Convergence and Divergence indicator and I am going to cover more in-depth usage in a later article.
In the past, I would use this on two different time frames using the Dinapoli settings of 8,17,9. This chart show the daily chart direction of the MACD drilled down to the four hour time frame.
The first uptrend area gave a trade off of a prior area of resistance just off the view of this chart.
We turn over and are only looking at shorting and price rallied up to a previous support area, tested, and dropped.
We hit a zone where the MACD lines were hugging and that would have us in a no trade zone (NTZ) as direction was not clear.
Currently, the MACD is registering a shorting condition on the higher time frame and this zone has two areas of interest. The first is not marked but it is where price found support during the previous downtrend which was then broken through. A revisit to that zone or the one above may give a setup and you have to use your triggers to get you into the trade.
There are traders who use the cross of the MACD lines as a trigger into a trade. I personally have never used it in that fashion at these higher settings.
I find it far too slow.
Just by looking at the above chart, you can see that using it as a trigger, you would have gotten a trigger long after the market advanced in the buying condition. In the selling condition, you would have missed that trade altogether.
I have removed the slow line so you can focus on the fast line of the MACD.
Notice the price made a lower low than the one before it.
The fast line has put in a higher trough than the previous. While you would not take a trade based only on divergence, it may have you tightening stops on current trades. This is showing that the current run of momentum is coming to an end (or at least a pause).
Depending on your experience as a trader and your work with the MACD, you may (in this example) be prepared to buy the first dip after price advanced if price showed some push to the upside.
Looking once again at the red line, you can see that it went almost vertical which indicates a healthy amount of momentum at this time. Looking for a pullback or a range and then break out pullback may have you considering a long trade.
More MACD To Come
In future articles, I am going to cover other ways to use the MACD as a trading tool.
There are ways to use it as a trigger into a trade as well as alert you what to do with the next swing in price.
In the meantime, try some multiple time frame trend determination to see if it’s something that catches your interest.
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