MACD Explained In Details

FinanceTrading / Investing

  • Author Kevin L. Johnson
  • Published October 13, 2012
  • Word count 898

Understanding the principle behind MACD is relatively easy. MACD is a calculation of the difference between the 26 day period and 12 day period EMA which stands for Exponential Moving Averages. The difference in the two EMA's that calculates the MACD indicator is the length of the period it's calculating, in most cases it will be the value = day with the 12 day EMA being the shorter making it a faster to respond than the 26 day EMA. The calculations are based on the closing prices of the moving averages of what time frame is being measured. Also on the MACD plotting area, there will be a 9 day EMA which is the MACD trigger line for the buy and sell executions. MACD is considered to be a bullish signal when above the 9 day EMA, and a bearish signal when it is below the 9 day EMA.

Most Traders find the MACD histogram beneficial because of the ease of visually seeing the difference between 9day EMD and MACD. You can quickly identify that the MACD is positive when its above the 9day EMA and negative on the histogram when the MACD is below its 9day EMA. If there is acceleration in price movement to the up side the histogram will plot larger and will reduce as the price decelerates giving a great visualisation.

Because of the speed in which the MACD Histogram is printed and also the fact that this technical indicator measures momentum, lots of traders use it to identify direction of trend, strength of trend and, as mentioned before, momentum of their current trend. But more often than not traders use it for gauging the strength rather than direction.

Learn How To Trade Divergence

Trading the divergence is by far the most common way of using MACD histogram. Identifying the most commonly traded setups is relatively easy to see on the charts which is when price makes a new pivot high or a new swing pivot low but the MACD does not follow the price that notifies the trader of the divergence in price action and momentum.

This, however, is not a fool proof trading system to follow as more often than not this divergence trading systems fails. Because this technical indicator is identifying momentum the price swings can often be very volatile which can force the traders stop loss putting the trader on the sidelines before the actual move. These are considered to be fake trading signals by many traders which result in the trader becoming extremely frustrated with the divergence trading system.

Entry and Exit Signals Using MACD Histogram

I have seen many discussions in online trading communities where they advise you to take a smaller trading position on the initial trigger and when you are proved correct in the trade add to your position limiting losses and maximising gains. I, however, do not feel that this is the correct advice to be giving in trading forums as it can be misinterpreted very easily. For example what they are telling you to do is: take a small short position at the point of negative divergence, then instead of placing a stop at the price action swing high, you place it at the high of the MACD histogram so that if then you get stopped out it is only because of being wrong and not because you place your stop to tight on the price action swing high. So then on the other hand if it does not make a new histogram high then you're well positioned to add to your position getting a better average price on your short.

This for me is why I don't consider this trading strategy to be one I would ever recommend to any new trader starting out. This type of trading strategy requires the trader to average down or up as the price action goes against them. This is what I would consider to be a strategy that could damage your trading account in no time at all. Adding to your losers is what I consider this strategy to be. Strangely people often try and justify this style of trading by suggesting that you're 'jumping on the train' before it leaves the platform but in my opinion this is a very poor justification as you could simply do the same with any technical indicator. Like with all of our stock market education we believe that it is best to combine technical indicators with price action chart pattern signals. This over time will keep you out of fake trading signals and give you a higher hit rate when trading the market.

General Conditions for Trading

My advice with any approach you take to trading the markets is that it is rarely seen to be black and white. Everything you have been taught in your trading education can never prepare you for the split decisions you will have to make in live financial trades. However being logical and following your trading methodology and fixed rules should allow you to, over time, become consistently profitable. There will, from time to time, be situations where you might have to be flexible outside of the rules in your trading plan but as long as these rules have been calculated in advance, it can often lead to maximising gains you may not have had by sticking too firm to the plan. This will however happen with experience and screen time.

As always feel free to check out our website for more information and videos on the subjects covered inside this article. We have explained how to trade MACD in conjunction with other indicators.

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