All About MACD from a deferent angle

 

Talking Points:

• While no indicator is perfect, they can help traders address probabilities in a market
• Moving Averages can be helpful, but often lack an active signaling mechanism
• MACD takes trading with moving averages one step further

The journey for most traders starts in a similar way…

Traders are drawn to markets because of the potential. And like anything else in life, most people understand that training and education are vitally necessary parts of success. Most will then act on this understanding, and will begin learning the ‘tools of the trade.’

And that is where the quest will begin…

In the FX markets, Technical Analysis often receives a heavier portion of this focus and there are a couple of different reasons for that. This journey of learning technical analysis can be a short couple of days or might take years or even decades. Regardless of how the trader approaches learning Technical Analysis, one thing that is fairly uniform is that the ‘common’ indicators are learned first before more advanced studies like price action or Elliot Wave.

These are the indicators like RSI, or Stochastics, or Pivot Points. And what will often happen is that after a trader learns how to use the indicator, they also learn that the indicator isn’t a panacea, and is from time-to-time, incorrect.

Does this mean that the indicator is worthless and can’t be used?

Absolutely not! It merely reiterates what all of us should know about markets going in… which is that markets are unpredictable no matter how you approach them.

Rather, trading is but a series of probabilities; and indicators can be helpful tools to look to trade with those probabilities.

In this article, we’re going to examine one of the more versatile indicators that is also one of the first discarded by new traders in their initial trading education: MACD.

The MACD Line

MACD is an acronym that is short for Moving Average Convergence Divergence, which is really just a long and drawn out way of saying it measures the relationship of moving averages.

The moving average is, in-and-of-itself, a very formidable indicator. It’s easy and simple and it just averages the last X periods worth of closing prices. The moving average is often the very first indicator learned because of how simple it is to teach and understand. And the benefits of trading with a moving average can be very clear and apparent, especially if the indicator is being used for trend analysis.

But, trading with a moving average doesn’t always work; and so traders will then learn the benefit of the moving average crossover. By adding a second moving average, we stand the chance to be able to ‘slow down’ the indicator signals. Whereas trading with one moving average entailed buying or selling when price crossed over, the crossover waits for one moving average to cross another before triggering a signal.

But, once again – this doesn’t always work. And this is where MACD comes into play. Traders wanted a way to try to enter the position at the early stage of a move… far before a moving average crossover might take place.

So, rather than watching moving averages, these traders plotted the difference between the averages as an oscillator (shown below).

MACD measures the spatial relationship of exponential moving averages

Created with Marketscope/Trading Station II

In this example, a 13 (in green) and 34 period (in blue) EMA is shown on the price chart. Notice when the two moving averages cross (highlighted with the red circle), MACD correspondingly crosses the ‘0’ line.

As the distance between the moving averages grows larger (or diverges), MACD moves lower to illustrate the growing difference that’s being seen in the EMAs.

On the flip side, when prices move higher, MACD will begin moving higher to reflect the convergence of the Exponential Moving Averages. If price moves high enough, MACD will eventually go up and over the ‘0’ line, and if prices can continue moving higher, the distance between the 13 and 34 period EMAs will also grow, and MACD will again show that divergence (this time to the up-side with an increasingly large MACD value).

This is the MACD line, and it’s the heart-and-soul of the indicator. But, at this point, there is no difference between the MACD line and a simple moving average crossover.

The Signal Line

The MACD line can bring a lot of value, in-and-of-itself, but it’s far from a panacea. After all, MACD is just the spatial relationship between those two EMAs, and if that’s what one wants to trade for, why not just follow a couple of moving averages?

The next part of the indicator is a key element to trading with MACD, and this is called ‘the signal line.’ The signal line is a moving average applied to MACD. By default, the signal line is usually a 9 period EMA; but this is really up to each individual trader. So, the signal line is a moving average based on the difference between two other moving averages. While this may sound confusing, do not worry – most charting packages can do this for you fairly easily and you don’t have to perform the mathematical computations for each.

By applying the signal line, the trader opens up the possibility of entering the trend far before a crossover of the 13 and 34 period moving averages would usually allow.

As an example, take a look at the previous setup we had investigated when MACD crossed down and under the ‘0’ line (and when the 13 and 34 period EMAs had crossed); but this time we’re going to apply the signal line to MACD.

MACD crossover with signal line will takes place far sooner than the crossover of Moving Averages

Created with Marketscope/Trading Station II

This is the benefit of MACD: The fact that it may allow for an earlier entry into a trend is what makes this such a phenomenal indicator. Sure, it won’t work all-of-the-time, but this is trading and there is nothing that works all-of-the-time.

MACD can make for a fantastic indicator in strategies because of just this feature; and if often functions best as a ‘trigger’ into positions in trend-based strategies.

The Histogram

The last part of the indicator is a further extension of the mathematical relationship between all of these moving averages.

The histogram measures the difference between the MACD line, and the signal line. When MACD crosses the signal line, the histogram goes to a value of ‘0.’

The Histogram measures the difference between MACD and Signal lines

Created with Marketscope/Trading Station II

As you can see in the above image, as the MACD and the signal lines converge or diverge; the histogram will reflect this properly. As MACD falls further underneath the signal line, the histogram will print lower to reflect this growing difference.

As MACD crosses over the signal line, the histogram will crossover ‘0’ and will continue to move higher as long as MACD continues moving higher above the signal line.