Trading With The MACD

The MACD ( moving average convergence divergence ) indicator designed by Gerald Appel is a trend-following/momentum indicator that uses 2 exponential moving averages (EMA) to:

+ Give buy and sell signals to enter and exit the market

+ Show bullish divergence/bearish divergence and negative divergence as well

+ Helps determine trend direction in both price and momentum

Some traders will also include the histogram that will cross the zero line when the EMAs cross in either direction.

In this article, you are going to learn:

+ How to determine the momentum trend using the 2 line cross

+ How to read momentum using the fast line

+ The benefits of multiple time frame analysis

Always remember that a trading indicator is a derivative of price, a trading tool, and will have some lag to current price action.  The MACD can be used with swing trading strategies as well as day trading and even scalping strategies.

MACD Settings

The MACD default setting are: 12, 26, 9 which represents the values for:

+ The lookback periods for the fast line (12)

+ The lookback period for the slow line (26)

+ Signal EMA (9)

As with any trading indicator, I always start with the input parameters that were set out by the developer and later determine if I will change the values.

MACD Calculation

This leads us to how the MACD calculates its output using the closing periods:

+ The 12 period EMA calculates a number for this period

+ The 26 period EMA calculates a number for this period

+ Subtraction of the 26 EMA result from the 12 EMA result

+ A 9 period EMA is calculated from 26 EMA – 12 EMA

How does the indicator work?

The MACD indicator is generated by subtracting two exponential moving averages (EMAs) to create the main line (MACD line), which is then used to calculate another EMA that represents the signal line.

What is the signal line?

Signal line is a 9 EMA of MACD line.  When the MACD line and signal line cross, it’s usually considered a trend reversal signals, especially when they happen away from the zero line.

MACD Settings For Intraday Trading

As with any technical analysis indicator, you can change the input values depending on your needs.  Intraday traders may want a faster indicator to cut down on lag time due to their short term trading style. The search for the best settings for any indicator is a trap many of us have fallen into at least once in our trading.

You must test any changes you make to ensure it actually adds to your trading plan.  Often times, a faster trading indicator will give many false signals so you must be aware of the trade-off.  That said, one very popular combination of the MACD is 3, 10, 16 which is a variation of the 3/10 oscillator.

I highly suggest that before you start crunching numbers and looking for short term macd settings for faster signals, you know exactly how the MACD works and determine if it will benefit your own trading.

What Does The MACD Measure?

The MACD line is faster than the signal line and is the result of the difference between the fast and slow EMAs.

Momentum Oscillator

When you see a signal line crossover of the faster MACD line over the signal line, we see a visual representation of  a change in the direction of momentum.

There are traders that will use the shift in momentum as the direction they want to trade in.  Momentum direction and price trend direction is not always the same direction.

 Price Trend Direction

A crossover of the signal line over the zero line is often used for trend direction .  Traders can use the momentum aspect as a sign of a pending trend change.  The zero line cross can be a confirmation of trend.

+ Bearish signal – Fast MACD line crosses from above to below the slow line

+ Bullish signal – Fast line crossover from below to above the slow line

Knowing that we measure trend and momentum, you may already see how we can use the MACD to actually trade with when we use both the MACD line and the signal line to alert us to a possible change in the market we are trading.

The 2 line cross can be a very powerful indication of trading potential in the market and is my preferred approach.

Zero Line Crossover

MACD crossing above zero is considered bullish, while crossing below zero is a bearish signal.  This is also expanded to include bullish and bearish momentum when the lines cross regardless of which side of the zero line.

MACD Momentum Trading Strategy

We have set up the indicator on our chart and are going to use the standard settings as previously discussed and learn how to read the MACD.

For this strategy, we are using the momentum feature of the MACD plus breaks of swing highs/low that also take place when an imbalance of buyers/sellers are present.

When we want to determine trend direction via the MACD for this strategy, we look where the MACD line is in relation to the signal line.

Strategy Details (Uptrend Example)

+ Mark off current swing high and low points

+ Price breaks swing high confirms uptrend is still in place

+ EMA cross on the MACD shows momentum to the upside

+ Use buy stop orders at high of candle that broke swing high/turned the indicator bullish via the crossing

Can we improve on this?

We can use multiple time frame trading by trading in the direction of the higher time frame momentum.

This is a one hour chart and the daily chart has bearish momentum.  We would only trade breakdowns through support with confirmation via MACD.

If price gaps through support, we would not take the trade.

The power of this approach is we have the bearish daily chart momentum at our backs when going short on the smaller time frame.

MACD Combinations

My favorite combination of trading indicators is the MACD + Keltner channels and price action.

+ Keltner channels would show a market that is extended and prime for a retrace

+ We look for a piercing of the upper or lower Keltner channel to show extension

+ MACD can show loss of momentum or divergences

+ Keltner is set to 20 periods with a 2.25 multiplier

Price is making lower lows while piercing the lower Keltner channel.  This is showing an extended market (oversold conditions) and while traders love to counter trend trade, we need another event to happen.

What Is a Divergence?

Divergences form when the MACD heads in one direction while price movement is in the other direction

In the black circle, we have price break lower, pierce the channel, and then we get a cross up.  This cross shows momentum to the upside while price is making a lower low and is known as positive divergence.

We want to trade the reversal as this is our buy trading signal.

Entry can be a buy stop over the red candle, green candle, or a break of the small trading range.

Targets will be the middle channel line and the upper Keltner band.  Trend reversals can often start from this condition so having a trading plan that includes some type of trailing stop method may be worthwhile.

Trading With The MACD – Key Takeaways

As will all technical indicators, you want to test them as part of an overall trading plan that includes:

+ Entry and exit criteria

+ Risk management

+ Markets and timeframes you will trade

What default values are used with the MACD?

The values of 12, 26 and 9 are the typical settings used with the MACD. Other values can be substituted depending on your trading style and goals.

You may also want to experiment, as with any moving averages, consolidation plays when the 2 lines of the MACD converge.  When this happens, price is usually in a range setting up a possible break out trade.

Is the MACD good for day trading?

Any indicator can be used for intraday trading and traders will often look to “tweak” default settings.  Indicators will react more to faster price changes and can give more false signals.  The MACD is a popular tool for all trading styles.

What is a good indicator to use with MACD?

Using a moving average can be useful when looking for pullbacks after MACD makes a new momentum high or low.  Also consider using price structure zones of support and resistance as well as Keltner Channels and Bollinger Bands

Is the MACD reliable?

I have found the MACD to be reliable when looking at negative and positive divergence plays. Price action always dictates if I take a trade and not the indicator itself.