What is the MACD indicator?
The “MACD”, which is short for Moving Average Convergence Divergence, is an indicator used to identify momentum in the market. It’s a momentum oscillator that’s calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. This results in a line, referred to as the MACD line, which oscillates above and below the zero line. In this article, we will discuss the basics how to use the MACD indicator to add confluence fo your trading strategy.
Ideal MACD settings
The default settings for the MACD indicator are 12, 26, and 9. You can of course adjust these inputs to preference.
If you research what the “best settings for the MACD” are, you’ll get a variety of different answers.
Some traders suggest using longer periods for a more stable reading of the market, while others use shorter periods to make it more sensitive and quicker to respond to the price action.
I’d suggest starting with the default settings, as that’s what most traders will be looking at. Once you get used to how the MACD works in general, you can then play around with different settings. Backtest the results to see what works best for the particular timeframes you like to focus on.
MACD Strategies
The primary way to identify uptrends is to look for higher highs and higher lows. A downtrend, of course, is indicated by lower highs and lower lows. Price action trumps all indicators when it comes to identifying trends.
That said, you can use the MACD to identify the momentum of the price action. When the MACD line is above the signal line, the momentum is bullish, and when it’s below the signal line, it’s considered bearish to be in bearish territory.
Crossovers: Some traders use a crossover strategy. They look for when the MACD line crosses above or below the signal line. If it crosses above, they consider it bullish and enter a long trade. If it crosses below, they consider it bearish and go short. Crossovers can be a strong signal of a potential trend reversal, however I find these signals to be much more reliable on longer time frames. If you attempt to trade shorter timeframes based on these crossovers alone I doubt you’re going to be profitable.
I personally find that these crossovers happen rather late in the move. To get my signals earlier, I prefer to use the histogram.
Histogram: The MACD histogram is a visual representation of the distance between the MACD line and the signal line. When there’s a lot of space between those EMA’s, the histogram prints bars that get progressively larger. As the gap between the MACD line and signal line decreases, the histogram will display bars that get progressively smaller.
Histogram bars (typically green) that are printing above the zero line indicate that the momentum of the price action is bullish. Bars printing below the zero line (typically red) indicate that the momentum of the price action is bearish.
I personally use the histogram for 2 reasons. The first, is to identify shifts in momentum, and the second is to spot divergences. I oftentimes totally disable the MACD and signal lines so they don’t even appear on the indicator.
How do I use it? I prioritize price action, first and foremost. If the price reaches a support or resistance level that I have marked out, I then look to my indicators to see if the momentum is weakening to get an early sign that a reversal is coming.
The MACD histogram is one of the tools I often use for this. Here’s what I look for, in order of importance.
- Candlesticks that indicate indecision and a reversal
- Divergences on the RSI and the MACD histogram
- Histogram bars getting smaller (and changing to the lighter colour shade) to indicate a momentum shift after a strong trend
Here’s how to spot divergences using the MACD histogram
Bullish divergences occur when the price is making lower lows while the MACD is making higher lows, and bearish divergences occur when the price is making higher highs while the MACD is making lower highs. These divergences can be an early indication of a potential trend reversal and traders can use this information to enter or exit trades at key levels.
The following is a bitcoin chart, and as you can see, the histogram shows that the momentum of the move was weakening prior to the price drop. Traders who knew how to look for these divergences (and trusted the signals) were able to exit the market near the top and avoid getting crushed in a brutal bear market.
The MACD indicator used in the above image is called “MACD histogram divergence”, as it’s available for free on TradingView (sign up here if you don’t already have an account).
You might be wondering what the “R” means in the above image. The “R” stands for Regular, which is referring to the type of divergence it was.
If you’ve read the lesson on how to use the RSI indicator, you know that there are regular divergences (as shown in the examples above), and there are hidden divergences.
Hidden divergences can be trickier to spot to the untrained eye, but if you can identify them, they’re quite powerful because they tend to be trend continuation signals. You’ve probably heard this by now, but the first lesson in trading is usually TRADE WITH THE TREND.
What’s a good MACD trading strategy?
Your top priority should be learning how to trade based on price action. This means you need to learn chart patterns, candlesticks and how to mark up support and resistance zones.
That being said, once you have that foundational knowledge, indicators like the MACD can be used to give you extra information for confluence.
Here are a couple good trading strategies that utilize the MACD.
Summary
The MACD is a powerful technical indicator that can be used to identify trends, momentum, and spot divergences in the market. It’s more useful when trading markets that have a strong trend (bullish or bearish) rather than markets that are stuck in a range.
Using the MACD as a standalone indicator isn’t recommended. Instead, combine it with other primary indicators such as support/resistance levels, candlestick analysis, trend direction, chart patterns and volume. Use the MACD as confluence to get more confidence in your entries and exists.
