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The Moving Average Convergence Divergence indicator, known as the MACD, is a popular technical analysis tool among all kinds of traders. Invented by Gerald Appel in the 1970s, the MACD has been around for a long time. The fact that it still helps millions of traders today is a testament to its reliability.
When I began, I tried a few indicators, such as the RSI and Stochastic Oscillator. I first learned about MACD while trading crude oil futures, but didn’t truly appreciate it at first. It was challenging. I would make judgments about the market direction using the MACD, and place trades. After some initial success, my trades were suddenly failing. I studied it more, but this process happened repeatedly, as I continued to apply its principles on a generalized way. Once I realized my mistakes, however, I realized how powerful this indicator really is.
While the concept is somewhat simple, the way it illuminates the current market conditions are priceless. For those new to trading, think of the MACD as a measure of momentum. It provides insights into the strength and direction of price movements, especially during strong trends. In weaker trends, the MACD helps you see exactly what’s happening when price seems to be stagnating.
In this article, I’m going to teach you all about the MACD. We’ll cover how it’s calculated, what signals it provides, and then see some examples of how to use it correctly. If you pay attention, and practice it enough, I am sure you will soon appreciate the insights it provides.
What is the MACD indicator, actually?
The MACD is based on the relationship between two moving averages, usually the 12-day and 26-day Exponential Moving Averages (EMAs).
If you’re unfamiliar with moving averages, they are some of the more basic indicators that traders use to analyze price action. Simple Moving Averages calculate the simple average of price over a certain period, while Exponential Moving Averages apply some extra weight to recent prices.
The MACD tracks the difference between these two EMAs and compares it with its own line, called the signal line. Using these lines together, traders can spot crossovers and divergences within the MACD, which provide signals for potential trend reversals and trade opportunities.
If that’s confusing, don’t worry, I’ll get into the specifics of these calculations shortly.
For now, think of the MACD as a measure of momentum. It’s most effective when used in trending markets, so you can employ it in your trend-following strategy. This means that when the market is moving in a clear direction, either up or down, the MACD will helps depict the strength and sustainability of the trend.
However, during periods of sideways or range-bound markets, the MACD takes more work to use correctly. If you’re looking for crossovers and divergence in these markets, signals are not going to be as reliable if taken at face value. It is crucial to understand these limitations and use additional tools and analysis to confirm the MACD signals.
In the following sections, we will delve deeper into the MACD indicator. You will learn about its components, interpretation, trading strategies, and limitations to help you harness its potential for successful futures trading.
Let’s get Technical: The MACD Indicator Components and Calculation
Understanding a technical indicator for the first time can feel like learning a new language. It’s a bit foreign and confusing to try to follow a new chart embedded within your candle chart. To appreciate the MACD’s utility, it’s essential to understand its components and how they are calculated. The MACD chart comes with three main parts: the MACD line, the signal line, and the histogram.
The MACD Line
This line represents the difference between the short-term and long-term Exponential Moving Averages. By default, the long-term is a 26-day average, and the short term is 12. When the short-term EMA is above the long-term EMA, the MACD line is positive, indicating bullish momentum. Conversely, when the short-term EMA is below the long-term EMA, the MACD line is negative, signaling bearish momentum.
The Signal Line
This line is calculated as the 9-day EMA of the MACD line and serves as a “smoothing agent” to filter out the noise in the price data. It acts like a compass, helping you keep track of the underlying trends, while reducing the impact of short-term fluctuations. Appropriately named, traders often use this line as the base, while following the MACD line’s behavior for potential trade signals.
The MACD Histogram
The MACD histogram visualizes the difference between the MACD line and the signal line. You can determine this quite easily yourself, but the histogram helps depict the size of the difference as well. When the histogram is above zero, it means that the MACD line is above the signal line. This means that there’s more momentum associated with the price moving higher, at the current moment. When the histogram is below zero, the MACD line is below the signal line, indicating bearish momentum. In addition, when the histogram bars are considerably large, it means the market is extremely strong, in either direction.
Calculating MACD
We’ll use the default values of 26 for slow EMA, and 12 for fast EMA, and 9 for the MACD line.. First, calculate the 12-period EMA of the closing prices:
EMA12 = [ (Current Close – Previous EMA12) * (2 / (12 + 1)) ] + Previous EMA12
Next, calculate the 26-period EMA of the closing prices:
EMA26 = [ (Current Close – Previous EMA26) * (2 / (26 + 1)) ] + Previous EMA26
Then, calculate the MACD Line:
MACD Line = EMA12 – EMA26
Finally, calculate the 9-period EMA of the MACD Line, which serves as the Signal Line:
Signal Line = [ (Current MACD Line – Previous Signal Line) * (2 / (9 + 1)) ] + Previous Signal Line
From here, we can easily determine the histogram, by calculating the difference between the two lines on the MACD:
Histogram = MACD Line – Signal Line
MACD Interpretation and Signals
Understanding the MACD’s components and their interactions will help you interpret the signals they generate. There are three primary signals produced by the MACD indicator:
Crossovers
A crossover occurs when the MACD line (the difference between the 12-day and 26-day EMA) crosses above or below the signal line (the 9-day EMA of the MACD line). When the MACD line crosses above the signal line, it is considered a bullish signal, indicating that it might be an opportune time to buy. Conversely, when the MACD line crosses below the signal line, it is considered a bearish signal, suggesting that it might be an appropriate time to sell.
For example, if a trader observes the MACD line crossing above the signal line, they may consider it a potential buying opportunity. However, it’s crucial to note that crossovers can occasionally produce false signals, and it’s essential to use additional technical analysis tools to confirm the signals’ validity.
Divergences
A divergence occurs when the price movement of the underlying asset and the MACD indicator move in opposite directions. This discrepancy can indicate a potential trend reversal.
A bullish divergence occurs when the asset’s price forms lower lows, while the MACD forms higher lows, suggesting a possible upward trend reversal. On the other hand, a bearish divergence occurs when the asset’s price forms higher highs, while the MACD forms lower highs, indicating a possible downward trend reversal.
For instance, if a trader notices a bearish divergence between the price and the MACD, they may consider it a warning sign of an impending trend reversal and take appropriate action, such as tightening their stop-loss or exiting a long position.
Histogram Reversals
The MACD histogram represents the difference between the MACD line and the signal line. When the histogram moves from negative to positive territory, it indicates a bullish signal, suggesting that the momentum is shifting towards the upside.
Conversely, when the histogram moves from positive to negative territory, it indicates a bearish signal, suggesting that the momentum is shifting towards the downside.
Suppose a trader observes the MACD histogram transitioning from negative to positive territory. In that case, they may interpret it as a bullish signal and consider entering a long position or adding to an existing one. However, as with other MACD signals, it’s crucial to use additional technical analysis tools to confirm the histogram reversal signals and avoid potential false signals.
Limitations of the MACD, and How to Overcome Them
Personally, I don’t find that there’s much more I could ask for from such a powerful indicator. After using it for years, I have gotten quite familiar with it. However, if you use it with a simplistic approach, you are going to have some issues as market cycles change.
Your trading consistency will not drastically improve by adding indicators to your chart and blindly trading off of them. Each of these limitations is easily solved by using more thought with your strategy. Let’s look at some of the solutions to the following limitations when it comes to the MACD.
The Lagging indicator Conundrum
Being a lagging indicator, MACD follows price action and provides signals after the price has moved. This can lead to delayed entries and missed opportunities, especially in fast-moving markets. But is this surprising? Indicators, on their own, cannot forecast the exact price and use it in their calculations.
The solution? Considering this isn’t really a problem, I recommend simply being more familiar with the indicator itself. The best way to get this familiarity is to simply use it hundreds or thousands of times, in different market conditions.
False signals
False signals include crossovers that don’t result in a significant price movement or divergences that fail to materialize into reversals. The solution is simple, but requires a bit more work. Use additional tools like support and resistance levels, trendlines, and other technical indicators. Confirm the validity of the MACD signals before you trade off of them.
Inconsistencies in Different Market Conditions
The MACD lines and signals can appear similar during different market conditions. This will throw you off if you expect things to materialize the same way every time.
For instance, during a strong trending market, the MACD may signal a reversal coming, and the market may simply power through momentary support or resistance after some time. During sideways or choppy markets, it may produce the same signal, and reverse completely. Traders relying too heavily on a specific situation that occurred in one time frame may neglect the power of stronger trends and their stubbornness to change.
This is, again, an issue only for those who apply it in a rudimentary way. The solution is to simply learn more about market conditions, and apply the appropriate MACD concepts accordingly.
Parameter Settings
The default settings for the MACD (12, 26, 9) may not be suitable for all traders or market conditions. Depending on your trading style and preferred timeframe, you might need to adjust these settings to optimize the MACD’s performance. Experiment with different parameter settings to find the best fit for your needs. Scalpers, for example, may not want to track the fast EMA across 9 candles, and so they may use a lower number like 6 or 7.
Conclusion
I hope this post helps you see some of the things that go into the MACD indicator, and how it can be used more effectively. I am confident you will enhance your futures trading if you practice using it extensively.
Remember that no single indicator is foolproof, and traders will make human errors. The MACD is no exception. Employing it by itself, without a clear plan and understanding of the general market, is not enough to profit consistently.
Play around with the settings, try multiple markets and time frames, and just observe how the indicator reacts. See what happens when there’s a strong trend, and what the MACD crossover predicts. Then, see what happens during a slow-moving, choppy morning in your favorite market. Does the crossover happen more or less often, and does it cause a larger or smaller move?
Then, pair it with some other tools, like support and resistance. See what happens to the MACD line as it hits a significant, proven support level. What does the price do at that moment?
Finally, if there’s a specific indicator you’d like me to cover, feel free to request it below.
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