MACD (MOVING AVERAGES CONVERGENCE DIVERGENCE)
MACD is an indicator used to identify moving averages that are indicating a new trend, whether it is uptrend or downtrend. After all, the most important thing in trading is being able to find a trend, because that is where you can make most of the money.
MACD indicator contains 3 components, which are;
MACD Line: It is the difference between the 12-period EMA and the 26-period EMA.
Signal Line: The Signal line is the 9-period EMA of MACD Line.
Histogram: It is derived from the other two components of the MACD; MACD Line and Signal Line. The histogram plots the difference between the fast and slow moving average.
Within an MACD chart, you will often see three numbers (12, 28, and 9) that are used for its settings.
- The first number “12” is the number of intervals that is used to calculate the faster-moving average.
- The second number “26” is the number of intervals that is used in the slower moving average.
- The third number “9” is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
- The 12 represents the previous 12 bars of the faster-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 by vertical lines called a histogram (the green lines in the chart above).
Note; from the picture above,
If you have a look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.
This is known as Divergence due to the fact the faster-moving average is moving away or diverging from the slower-moving average.
The Histogram gets smaller as the two moving averages move closer to each other. This is known as Convergence due to the fact the faster moving average is “converging” or getting toward the slower moving average.
My buddy, that’s how Moving Average Convergence Divergence was formed.
HOW TO USE MACD INDICATOR
As you can see from the MACD chart, when the market is Bearish (downward trend), you would see that the Histogram is increasing below the zero line. Also, when the market is Bullish (upward trend), you would see that the Histogram is increasing above the zero line. Also, when a new trend happens, the fast line will react first and ultimately cross the slow line. When this “crossover” occurs and the faster line starts to move away (or diverge) from the slower line, it often indicates that a brand new trend has shaped (formed).
- Crossover is the point where faster line and slower line meet or intersect.
From the chart below, you can see that the fast line crossed above the slow line and correctly identified a new uptrend.
Note: The Histogram temporarily disappears when the lines crossed. This is due to the fact that the difference between the lines at the time of the cross is 0.
As the uptrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is an ideal indication of a strong trend.
Let’s take a look at an example.
In GPB/USD’s 1-hour chart above, the fast line crossed below the slow line at the same time as the histogram disappeared. This showed that the brief uptrend would eventually reverse.
GPB/USD began to move down as it started a new downtrend. Imagine if you went short (to sell) after the crossover, you would’ve gained some pips.
There is one disadvantage to MACD. It is a lagging indicator and it delays before it gives you sign whether to enter the market. So, most times, you can be late to the party, which is; “not catching up on the trend on time”. But despite the drawback, MACD is still one of the most favored tools by many traders.