hat is MACD?
MACD is the short name for Moving Average Convergence Divergence. This is an indicator that is used in technical analysis to detect changes in the direction of the trend, as well as the duration, strength and momentum of the trend.
MACD’s main function is to catch trends early and identify upcoming trend reversals.
This indicator contains 2 moving averages, as one of them is FAST , the other is SLOW, and vertical lines are called a HISTOGRAM. The histogram actually measures the distance(difference) between those 2 moving averages.
There is a common misconception that the moving average lines are moving averages of the price. But they are NOT! These lines are moving averages of other moving averages.
MACD’s disadvantage is that it is lagging, because it uses so many moving averages.
You will need to wait for the last line to “cross over” or “cross under” the slow line. Then you could open your position accordingly because it signals a new trend.
The standard parameters are 12,26,9 on most charting softwares.
But what do these parameters mean in reality?
- 12 – the previous 12 bars of the faster-moving average.
- 26 – the previous 26 bars of the slower moving average.
- 9 is the difference between the two moving averages, the previous 9 bars. It is placed as vertical lines – a Histogram (represented by the green lines in the chart above).
Let’s explain it better if you still don’t understand how it works.
In our case, the difference between the 12 and 26-period moving averages represents our faster moving average.
The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average.
This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average.
This smoothes out the original line even more, which gives us a more accurate line.
The Histogram simply plots the difference between the fast and slow moving average.
It may sometimes give you an early sign that a crossover is about to happen.
If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.
This is called a MACD divergence because the faster moving average is “diverging” or moving away from the slower moving average.
As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.
Ok, so now you know what MACD does. Now we’ll show you what MACD can do for YOU.
How to Trade Using MACD
Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.
When a new trend occurs, the fast line will react first and eventually cross the slower line.
When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend.
Notice that when the lines are crossed, the Histogram temporarily disappears.
This is because the difference between the lines at the time of the cross is 0.
As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is a good indication of a strong trend.
Let’s take a look at an example.
In EUR/USD’s 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend could potentially reverse.
From then, EUR/USD began shooting up as it started a new uptrend. Imagine if you went long after the crossover, you would’ve gained almost 200 pips!
There is one drawback to MACD.
Naturally, moving averages tend to LAG behind price.
After all, it’s just an average of historical prices.
Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag.
That said, MACD is still one of the most favored tools by many traders.