How to use the MACD
The MACD (moving average convergence divergence) is no doubt one of the most popular and best liked indicators in the field of technical analysis. The indicator basically consists of two exponential moving averages, which are used to measure momentum in the underlying asset.
The MACD is derived by plotting these 2 moving averages against a centreline. The centreline is that point where the two averages converge.
Along with the chart of the MACD itself and the centreline, traders use an exponential moving average of the MACD itself. The underlying concept here is that measuring short term momentum and comparing that with long term momentum will help the trader to determine the current direction of market momentum.
Fig. 11.08(a) is a chart of the AUD/USD with below that a chart showing the MACD.
The way the chart is interpreted is that when the MACD is above the centre line, i.e. when it is positive, it shows that the short term moving average is above the long term moving average. This is a signal that there is upwards momentum in the market.
The opposite is true when the MACD turns negative – this is a signal that the short term average has dropped below the long term average and that the market has developed downward momentum.
Most traders use an MACD chart where the long term average is represented by a 26-day chart and a short term average by a 12-day chart. The red signal line is usually created by using a 9-day EMA of MACD values.
These values can be adjusted according to the needs of the trader and market conditions. In volatile markets traders usually prefer to use shorter term averages, while in slow moving markets longer term averages could be more useful.
The series of vertical bars that can be seen in Fig. 11.08(a) are known as the MACD histogram. They are plotted on the centreline. Each of these bars shows the difference between the signal line and the MACD.
The higher these bars are, the higher the momentum in the market. When they start to taper off, it could be a good time to start thinking of getting out of a particular trade.
Take a closer look for example at points A and B in Fig. 11.08(a) for example. At point A the histogram started turning up and crossed the red signal line from below after it had enjoyed strong downward momentum. This turned out to be an excellent entry point for a long CFD trade.
At point B, on the other hand, the histogram started moving downwards and crossed below the red signal line from above – indicating that the uptrend was drawing to a close.
Like all technical indicators, the MACD is not flawless. It is easy to spot several points in Fig. 11.08(a) where it would have given unreliable signals. Experienced traders therefore nearly always use it in conjunction with another indicator, such as the RSI (Relative Strength Index) or the Stochastic Oscillator. When a trading signal on the MACD is confirmed by one of these other indicators, it provides traders with a higher probability of success than when using only a single indicator.