The MACD trading strategy has two lines. When these lines cross, it’s like a secret signal for traders. A bullish crossover, where the MACD line surges above the signal line, suggests that the market is gearing up for a thrilling upward journey. It’s a green light for traders to potentially buy and ride the wave of bullish momentum.
A bearish signal emerges when the MACD line dips below the signal line, suggesting a potential downturn in momentum. Forex traders frequently watch for divergences between the MACD and price movements to identify possible reversals.
Understanding MACD Indicator
The MACD concept is quite easy to learn. Each of these moving averages is calculated using the closing prices for their respective periods (26 days and 12 days). The signal line is marked as a symbol of purchasing and selling signals in the situation of the MACD line crossing it.
Types of MACD Strategies
1. Histogram
Traders frequently use the MACD histogram as a momentum indicator to predict changes in market sentiment.
There are three key components associated with the histogram, which is centered around a baseline:
- Imagine you have two averages of a stock’s price: a short-term average and a long-term average, their difference is the MACD line.
- To smooth out the MACD line, we take an average of it over nine days. This smoothed version is called the signal line.
- Finally, the histogram is a visual representation of how much the MACD line is changing compared to its smoothed version.
Many traders frequently rely on additional tools and techniques to assess and act on market sentiment, such as analyzing the trading volume of a specific security.
2. Crossover Strategy
A bullish signal fires up when the MACD line soars above its nine-day moving average, hinting at a potential upward surge in momentum. A bearish signal is indicated when the MACD line dips below its nine-day moving average, suggesting a potential decline in momentum.
3. Zero-Cross Strategy
When the MACD line goes above the zero line, it means the stock’s price might be going up. Traders often buy the stock at this time. On the flip side, when the MACD line dips below the zero line, it suggests a potential downward trend. This often leads traders to take short positions, betting on a price decline.
MACD with RSI and SMA
Traders frequently utilize a forex trading strategy that combines the MACD and the relative strength index (RSI) indicators. This approach enables them to leverage both the RSI and the SMA effectively.
The RSI helps traders gauge the strength of a trend while identifying potential reversal points along that trendline. It is typically plotted over a baseline of 14 periods and features two key levels: oversold and overbought. The specific levels chosen can vary based on the trader’s preferences and strategies, with some opting for more conservative thresholds of 20 and 80.
The simple moving average (SMA) is like a smooth ride through a stock’s price history. It’s a rolling average that takes a snapshot of the closing prices over a specific timeframe, giving you a clear view of the overall trend. This indicator assists traders in determining whether they expect a trend to continue or reverse.
By integrating these three strategies, traders can:
- Anticipate future price movements using the RSI
- Evaluate the power and predict the trend’s direction by using MACD
- Use of the SMA indicator that follows trends
How does MACD Trading Indicator Work?
The MACD indicator comprises two essential elements:
- Two Moving Averages
- Histogram
The MACD indicator utilizes two exponential moving averages (EMAs) to generate trading signals, named as MACD line and Signal line.
When these two EMAs are close together (MACD line and Signal line), they are said to be converging, and when they move apart, they are diverging. An uptrend is built when a MACD line is over zero range, on the other hand, the downtrend occurs in the case of a MACD line going down from zero range.
If the market price is trending upward—making higher highs and higher lows, and breaking through key resistance levels—traders may decide to enter long positions. When an asset is in a downtrend, indicated by consistently lower highs and lower lows or the breaking of support levels, traders may choose to sell the asset, anticipating further price declines.
Setting Up the MACD Indicator
In a MACD chart, you will usually find three figures for the settings of the chart.
- The first parameter sets the timeframe for calculating the faster-moving average.
- The second parameter determines the timeframe for calculating the slower-moving average.
- The third parameter sets the timeframe to evaluate the difference between the faster and slower-moving averages.
For example, in the given below configuration:
- 12: This means a moving average is calculated based on the past 12 data points.
- 26: This indicates a moving average calculated over the last 26 data points.
- 9: This parameter calculates a moving average of the gap between the two moving averages.
Components of MACD Trading Indicator
There is a common misunderstanding regarding the lines of the MACD.
There are two lines:
- The MACD Line
- The Signal Line
The MACD Line is created by taking the difference between a fast exponential moving average and a slower one, providing a dynamic view of momentum shifts. In the context of the indicator, the MACD Line is viewed as the “faster” moving average.
The Signal Line offers a refined perspective on the MACD Line, created by applying a moving average to smooth out its fluctuations and highlight key trends. It is regarded as the “slower” moving average, as it averages the previous values of the MACD Line.
Most charts default to using a 9-period exponential moving average (EMA) for this purpose, meaning it calculates the average of the last 9 periods of the “faster” MACD Line to create the “slower” moving average.
When the MACD Line and Signal Line move further apart, the Histogram bars become larger. Conversely, when the moving averages draw closer together, the histogram shrinks, a situation referred to as convergence, indicating that the faster-moving average (MACD Line) is “converging” towards the slower-moving average (Signal Line).
How to Trade Using MACD Indicator?
The faster-moving average will react more quickly to price action than the slower-moving average because they are set to different lengths or “speeds.” So when the new trend starts the faster-moving MACD Line is more reactive to price changes and will eventually cross over the slower-moving Signal Line.
The intersection or crossover of the two lines usually signifies that a new trend is forming, and when the fast line starts to diverge or moves away from the slower line, strong confirmation of this formation might be seen.
At the beginning of a downtrend, when the faster line diverges from the slower line, a larger histogram forms, signaling strong downward momentum.
How to Use the MACD Indicator?
Traders can utilize MACD signals to spot potential buying and selling opportunities in the market. Crossovers occur when the MACD line intersects the signal line, while divergences arise when the MACD line’s movement diverges from the asset’s price movement.
Given below are a few strategies to identify the buy and sell signals:
1. A bullish signal suggests that the asset’s price may rise shortly, prompting traders to consider purchasing the asset.
2. A bearish indication indicates that the asset’s price may fall soon, leading traders to consider selling it.
3. A divergence signal arises when the movement of the MACD line deviates from the price action of the underlying asset. A bullish divergence is like a secret signal from the market. This unexpected twist suggests that buying pressure might be building up, hinting at a potential upward price reversal. On the other hand, a bearish divergence happens when the MACD line creates lower highs while the asset’s price achieves higher highs, signaling a possible downward reversal in price.
Simple MACD Strategy
The entry points are determined with MACD signals exclusively. Under this strategy, orders are placed in the following manner:
- Upward Crossover: When the MACD histogram crosses its moving average upward, it can be interpreted as a bullish signal, suggesting potential upward momentum in the underlying asset. This might trigger a buy order.
- Downward Crossover: Conversely, when the MACD histogram crosses it is moving average downward, it can be seen as a bearish signal, indicating potential downward momentum. This might prompt a sell order.
Common Mistakes to Avoid
- Avoid Relying Solely on the MACD – It’s important not to base your trading decisions solely on the MACD. Always use additional indicators or analysis methods to confirm your findings.
- Don’t Overlook Market Context – Stay informed about broader market trends and economic news that could impact price movements. Consider MACD signals within this larger context.
- Don’t Enter Trades on Weak Signals – Steer clear of entering trades if the MACD signal appears weak or ambiguous (for instance, if it’s near the zero line). Wait for more robust confirmations.
- Don’t Apply Fixed Settings Across All Markets – Tailor the MACD settings to fit the specific market or asset you are trading.
- Don’t Rush into Trends – If the MACD indicates a trend reversal, take your time before entering a trade. Look for confirmation before proceeding, particularly in volatile markets.
Conclusion
In conclusion, MACD gives much flexibility for trading based on technical analysis through the MACD indicator. However, it does not perform well when used alone but, with the assistance of two or three best indicators, it can create a system having a good ratio of good to false entries that assure profit for disciplined traders.