The MACD indicator explained

Introduction

Moving Average Convergence Divergence (MACD) is a widely-used technical indicator popular with CFD traders in all markets, invented in the 1970s by American investment manager Gerald Appel. MACD is a trend-following indicator that uses the difference between two time periods on a moving average to generate buy and sell signals.

Trading using MACD is a popular technical strategy and the indicator allows CFD traders to identify momentum in different markets, with MACD identifying changes in trend direction shown by crossovers or changes in the relative position of the MACD line and signal line. MACD has been applied to all markets including FX, cryptocurrencies, indices and stocks by traders looking to gain an edge on the competition.

To use MACD successfully, traders need to understand both the basic maths behind calculating moving averages and plotting the MACD line, as well as how to correctly interpret generated signals. One danger with MACD is the presence of false signals, where market noise creates the misleading impression of a new trend, and another specific pitfall for CFD traders is using inappropriate time frames for their strategy.

Calculating the MACD

The MACD uses exponential moving averages, which are weighted averages calculated using past price data with more prominence given to the most recent moves. The closing prices of whatever period is being measured are used in this calculation: this is significant when comparing charts with the period measured in hours versus days, and CFD traders tend to use MACD on shorter timeframes. The MACD formula is below:

MACD = 12 period EMA – 26 period EMA

To calculate the MACD, you first plot the MACD line, which is the 26 period EMA subtracted from the 12 period EMA as per the formula above. A second line called the signal line is then plotted as the 9 day exponential moving average of the MACD line. MACD analysis relies on the interaction between these two lines, and signals caused by their crossover or other events. The MACD histogram is a chart that is often superimposed on the same axis as the two lines, and shows the MACD minus the value of the MACD signal line. The MACD histogram may be positive or negative, and is used as a momentum indicator in its own right.

Issues for CFD traders

Some analysts believe the MACD is not appropriate for intraday trading, since it observes longer-term averages and since any indicator using averages is lagging rather than forward looking. The point about day traders excludes most CFD traders, since typically positions are entered and exited very quickly. There are a few ways intraday traders can still benefit from MACD strategies though, either in their traditional form or by shortening the time period to hours.

Even though multi-day moving averages will tend to identify longer-term trends and erase out small intraday moves CFD traders deal with as noise, identifying the underlying trend is still very important for intraday traders.

If you have a system that produces long and short signals when prices trend in either direction, having a bias towards going long or short based on the prevailing long-term trend is an excellent way to improve your win rate. For example, you could ignore short MACD signals when the longer-term trend is up, or vice versa.

The other method for producing more valid MACD signals as a short-term CFD trader is to change the period from days to hours. Preserving the same ratios, you can simply calculate the closing prices of each hourly session and use that as your input instead of the daily close. When you select the MACD overlay on an hour-by-hour chart most charting software will do this automatically, saving you the bother of making any calculations. This then provides a smoothed intraday chart, with market noise reduced but still showing you the outline of the high-speed trends that impact your trading.

Interpreting MACD signals

MACD signals can be used in a few different ways. Simple MACD strategies include looking for MACD divergence, where the histogram extends as the MACD line and signal line move further apart.  MACD divergence can be used to generate signals, since when the histogram is positive it indicates the MACD is higher than its nine-day average (the signal line), potentially indicating a positive trend. The change in shape of the histogram is as important as its absolute size, with a growing positive histogram indicating bullish momentum. Conversely, when the histogram is negative, extending below the zero line, this is likely a bearish signal as the MACD line falls below its nine-day average.

Key MACD trading strategies

The most important MACD strategies are the histogram, crossover, and zero-cross. Though far from an exhaustive list, these three strategies are among the most useful to begin applying to your CFD trading. Each strategy is outlined in brief below, considering their application to CFD traders. Readers interested in learning more can find detailed information on the ADSS learning site.

Histogram

One simple MACD trading strategy is to use the histogram as an oscillator. The MACD histogram shows the difference between the MACD and signal lines, and can be used as a momentum oscillator similar to the relative strength index. Traders look at the MACD histogram as showing potential market reversals when momentum is over extended in either direction, but it is important to remember that MACD is based entirely on price data with no input of volume.

Momentum trading and mean reversion strategies require an understanding of order volume to reach accurate decisions, so use multiple technical methods to confirm before you open a position. The exact level at which the histogram is considered ‘overbought’ or ‘oversold’ will vary from trader to trader and market to market.

Crossover

The most frequent MACD strategy is the crossover, a simple strategy that produces signals when the MACD line crosses above or below the signal line. A bullish crossover occurs when the MACD line crosses above the signal line, indicating potential upward momentum. A bearish crossover occurs when the MACD line crosses below the signal line, indicating potential downward momentum. Once a crossover signal is identified and confirmed, often using other technical or fundamental methods traders need to determine entry and exit points.

For a bullish crossover, CFD traders will often enter a long position when the MACD line crosses above the signal line, and exit the position when the MACD line crosses back below the signal line or when other indicators suggest a reversal. For a bearish crossover, consider entering a short position when the MACD line crosses below the signal line, and exit the position when the MACD line crosses above the signal line again or when other indicators signal a reversal. Ensure that entry and exit points align with your risk management objectives and preserve a favourable risk reward ratio.

Zero cross

The zero-cross is an important subtype of crossover. A zero cross occurs when the MACD line crosses the zero line, indicating a change in momentum. The direction of the cross influences its interpretation: when the MACD line crosses above the zero line, it suggests bullish momentum, signalling a potential buying opportunity. Conversely, when the MACD line crosses below the zero line, this is normally seen as a bearish sign, signalling a potential selling opportunity to traders. This strategy is particularly useful for CFD traders looking to capture trend reversals or confirm the strength of an existing trend identified using other methods. Zero crosses can be seen in all markets, including commodities and cryptocurrencies.

Summary

The MACD indicator is a versatile tool that can be used by CFD traders to identify trends, momentum, and potential reversal points in various markets. By understanding how to calculate and interpret MACD signals, traders can make more informed decisions and improve their CFD trading performance. However, it’s essential to remember that no single indicator guarantees success, and MACD signals should be used in conjunction with other technical analysis tools and risk management strategies for optimal results.

MACD, either looking at line divergence or using the histogram as a momentum indicator, produces buy or sell signals that can be simply confirmed using other technical and fundamental methods. CFD traders tend to use MACD with shorter timescales than its users in long term equity trading, but the basic principles of the indicator are the same across timeframes and across markets. Understanding the MACD and how to trade it is one method you can use to trade more intelligently.

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