Do you know your trading tools? Like really know them? It is shocking that most traders use indicators such as the Stochastic, ADX and the MACD, but have no idea what they are actually doing, or even misinterpret the signals these tools provide. That’s why we have taken the lead to show you what your indicators are actually doing and how to use them properly. Today, we will take an in-depth look at the MACD indicator, one of the most famous indicators out there.
The two main functions of the MACD
The MACD has two main functions. It shows the momentum, the strength with which price moves, and second, the MACD provides trend-following information about the direction of a trend and whether a trend is likely to be over.
What is the MACD actually?
The majority of traders don’t actually know what the MACD is, other than some bars going up and down and a line that moves somehow along with it. At its core, the MACD is nothing but a 12 exponential moving average (EMA) and a 26 EMA. The bars you see in the MACD are just calculated by analyzing the two EMAs as we will see later.
The screenshot below shows the two EMAs. The 12 EMA is the faster moving one that reacts quickly to changing prices, whereas the 26 EMA takes a bit longer to change. In the following we explore how the MACD is created with these two EMAs. Basically, you wouldn’t need the MACD at all if you knew how to interpret these two EMAs…
How does the MACD signal momentum?
The size of the bars and the change of the size of the MACD bars provide information about momentum. When the bars are becoming greater, momentum is rising – the trend is becoming stronger. But how are the bars created? The bars in the MACD are nothing but the space between the 12 and the 26 EMA.
The following screenshot illustrates the point.
1) Price is moving down. The 12 EMA is moving down faster and is moving away more and more from the 26 EMA. The space between the two EMAs is becoming greater and, at the same time, the MACD bars are becoming larger to the downside as well – more bearish momentum.
2) Price is turning to the upside and the 12 EMA is moving up towards the 26 EMA. As you can see, the space between the two EMAs is becoming smaller and, therefore, the MACD bars are becoming smaller as well. The momentum to the downside is fading.
3) Price is moving up fast and the 12 EMA is rising faster than the 26 EMA. The space between the two EMAs is becoming bigger and, therefore, the MACD bars are becoming greater as well. A signal that bullish momentum is building up.
4) Price is turning down and the 12 EMA is heading down faster than the 26 EMA. Therefore, the space between the two EMAs is becoming smaller and so are the MACD bars. The bullish move is losing momentum.
Lesson 1: The MACD bars show the difference between the 12 EMA and the 26 EMA. When the MACD bars get wider, it means that the 12 EMA is pulling away from the 26 EMA and momentum is increasing.
How does the MACD show direction?
There are several ways of using the MACD to get information about the direction of price. The first one is to just look at what the bars are doing. When the MCAD bars are moving down, momentum is down. Here it does not even matter whether the MACD bare are positive or negative – you only observe the direction of the bars.
Lesson 2: The direction of the MACD bars provide information about the slope of the EMAs, regardless of whether the MACD bars are positive or negative.
To apply a stronger directional filter, you can look at whether the MACD bars are actually positive or negative. A positive MACD shows that the 12 EMA is above the 26 EMA and negative MACD shows that the 12 EMA is below the 26 EMA. Therefore, when the 12 and the 26 EMA cross, the MACD crosses from positive to negative as well. In its core, the MACD can be used as a moving average crossover filter as well, without having to plot moving averages directly on your charts.
Lesson 3: When the MACD is positive, the 12 EMA is above the 26 EMA. When the two EMAs cross, the MACD crosses from positive to negative as well.
What is a Divergence?
Divergences are famous because they can do two things. First, they can signal when a trend is over and help you take profits at the right time. And second, a divergence could give you an early entry signal in the other direction. But what happens on your charts when a MACD divergence forms? To fully understand we have to dissect what a divergence is in regards to price and the MACD.
Divergence in a nutshell: Price makes a higher high, whereas the MACD bars don’t.
1) The two EMAs are wide apart at the first high, showing that prior to the first high, price moved up sharply and momentum was high. You can see that the candles were bullish and large before it made the first high.
Between 1 and 2: Price moved down and sideways, while the two EMAs converged.
2) Price made a new high – higher than at point 1. However, the bullish move prior to high number 2 was slower than at 1 and the bullish price bars were smaller as well. This shows that the momentum leading up to the second high was lower compared to the first high.
The MACD bars show a loss in momentum. When price formed the first high, the MACD had large positive price bars showing great momentum, as described by the greater MACD. At the second high, the MACD bars are much smaller showing weaker momentum. This signals that although price made a new high, momentum was not favoring the move.
Conclusion: The MACD is your universal weapon
The MACD can be used for several different purposes as we have seen. To sum it up, here is what the MACD can do for you.
– The MACD provides information about momentum. Rising MACD bars show that momentum is building up and the strength of the price move is increasing.
– The direction of the MACD bars can tell you the direction of price.
– A cross from positive to negative MACD may signal a more accurate directional signal. The MACD can be used as a moving average crossover signal as well.
– A divergence shows that new highs/lows are not followed by increasing momentum. A divergence could serve as a first warning signal for a change in direction.
As usual, I have to say that using a MACD by itself to generate trading signals will probably not yield the results you are looking for, but adding the MACD to your repertoire and knowing how to use it correctly can dramatically increase your trading abilities.
You found this information useful? Then you will also like our articles about the STOCHASTIC indicator, the in-depth guide about moving averages or our candlestick cheat-sheet. What is your favorite trading tool you want to read more about? Leave a comment and we will make it happen!