What is the MACD?
MACD is an acronym for Moving Average Convergence Divergence.
This technical indicator is a tool that is used to identify moving averages that indicate a new trend, whether it is bullish or bearish.
After all, one of the top priorities in trading is being able to find a trend, because that’s where you make the most money.
With a MACD chart, you will normally see three numbers that are used for your setup.
- The first is the number of periods that are used to calculate the fastest moving average.
- The second is the number of periods that are used in the slower moving average.
- And the third is the number of bars that are used to calculate the moving average of the difference between the fastest and slowest moving averages.
For example, if you say “12, 26, 9” as the MACD parameters (which is usually the default setting for most graphics programs), this is how you would interpret it:
- The 12 represents the previous 12 bars of the fastest moving average.
- The 26 represents the previous 26 bars of the slower moving average.
- The 9 represents the previous 9 bars of the difference between the two moving averages.
- This is plotted using vertical lines called a histogram (the green lines in the graph above).
- There is a common misconception when it comes to MACD lines.
The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.
In our example above, the fastest moving average is the moving average of the difference between the 12 and 26 period moving averages.
The slower moving average traces the average of the previous MACD line. 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 fastest MACD line and plotting it as our slowest moving average.
This softens the original line even more, giving us a more precise line.
The histogram simply plots the difference between the fast and slow moving average.
Sometimes it can give you an early signal that a crossover is about to occur.
If you look at our original chart, you can see that as the two moving averages separate, the histogram gets bigger.
This is called MACD divergence because the faster moving average is “diverging” or 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 approaching the slower moving average.
And so, my friend, is how you get the name, Moving Average Convergence Divergence! Wow, we have to break our knuckles after that!
Okay, now you know what MACD does. Now we will 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 react faster to price movement than the slower one.
When a new trend occurs, the fast line will react first and will eventually cross the slower line.
When this “crossover” occurs and the fast line begins to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
In the chart above, you can see that the fast line crossed below the slow line and correctly identified a new downtrend.
Notice that when the lines cross, the histogram temporarily disappears.
This is because the difference between the lines at the time of the crossing is 0.
As the downtrend begins and the fast line moves away from the slow line, the histogram becomes larger, which is a good indication of a strong trend.
Let’s look at an example.
On the EUR / USD 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend could potentially be reversed.
Thereafter, the EUR / USD started to skyrocket as a new uptrend started. Imagine if it had been a long time after the crossover, you would have gained almost 200 pips!
The MACD has a downside.
Naturally, moving averages tend to lag behind price.
After all, it is just an average of historical prices.
Since the MACD represents the moving averages of other moving averages and is smoothed by another moving average, you can imagine there is quite a lag.
That said, MACD is still one of the most favored tools for many traders.