MACD – How To Use The MACD Correctly
The MACD is a momentum and trend-following indicator that is based on the information of moving averages and, thus, ideal to act as an additional momentum tool and momentum filter for your trading. In this article, we will explain what the MACD does, how it helps you analyze price and how to use it in your own trading.
First, let’s take a look at the individual components of the MACD indicator:
MACD Line: The MACD line is the heart of the indicator and it’s the difference between the 12-period EMA and the 26 period EMA. This means that the MACD line is basically a complete moving average crossover system in just one line.
Signal Line: The Signal line is the 9-period EMA of MACD Line
MACD Histogram: MACD Line – Signal Line
In this article, we focus on the MACD and the signal line in particular. The histogram is derived from the other two components of the MACD and, thus, don’t add as much explanatory value to overall MACD trading.
The basics of the MACD indicator
Since the MACD is based on moving averages, it’s ideal for analyzing momentum in price, finding trend-following entries and staying in trends until momentum is dying off.
There are 2 MACD signals in particular that we will explore in this article and explain step by step how to use the MACD to find trades:
1) The MACD Line cross 0
In the screenshot below, the MACD line is the red line and it’s based on the 12 and the 26 moving averages. You can also see that I plotted the two moving averages on the chart and when the two MAs cross, the MACD line crosses 0. As I said earlier, the MACD line is similar to a moving average crossover system and the 0 line cross shows that nicely.
As we know from our moving averages article, a cross of 2 MAs shows a change in momentum and often foreshadows the creation of a new trend. So, whenever the MACD Line crosses 0, it shows that momentum is changing and potentially a new trend is just being created.
1) The Signal Line
When you see the two MACD indicator lines move away from each other, it means that momentum is increasing and the trend is getting stronger. When the two lines are coming closer to each other, it shows that price is losing strength.
However, the MACD is an oscillator and during very strong trends, it won’t give very accurate information. Thus, when you are in a strong trend, don’t get confused by too many crossings of the MACD lines.
TIP: As long as the MACD lines are above 0 and price is above the 12 and 26 EMAs, the trend is still going on. In the video below, I show this concept in more detail.
Trend- following entry | scenario 1
During ranges, the two lines from your MACD are very close together and they hover around 0; this means
that there is no momentum and no strength.
When price breaks out and starts a trend, the two indicator lines pull away from the 0 line and also move away from each other. Then, during a trend, the moving averages can act as support and resistance and keep you in trends. When the price crosses below the EMAS the uptrend is over.
The same holds true for downtrends. At the beginning, or during a downtrend, the two indicator lines are pointing down and also show a lot of space between the lines. This shows strong downside momentum. A downtrend comes to an end when price crosses above the moving averages.
MACD trade entry | Example 2
The screenshot below shows another classic example how the MACD adds context to price movements. After the trendline break and when price broke the moving averages to the downside, a new downtrend was started. The MACD then also broke the 0 line and the two indicator lines moved away from each other as the downtrend gained momentum. At the bottom of the downtrend, the MACD showed a divergence, foreshadowing the loss in momentum and the end of the trend.
MACD divergences as early entries
MACD divergences are another great way to analyze price and find early trades. You can see in the screenshot below how price was moving higher very slowly over a long period of time. At the same time, the MACD moved lower showing that there was no buying strength behind the slow grind. Then, suddenly, price broke below the two moving averages quickly and also the MACD lines crossed below 0 giving a short entry. During the following sell-off, the MACD stayed below 0 and it allowed traders to ride the trend until the very bottom.
MACD vs RSI – which momentum indicator should you pick?
Traders always ask me whether they should use the MACD or the RSI in their trading!? And although the two indicators are very similar and I prefer the RSI in my own trading, I often suggest using the MACD in the beginning.
The MACD has two major advantages over the RSI which can help new traders make better decisions. First, the two lines of the MACD provide more information and, thus, are often easier to read for new traders. Secondly, the 0 line cross is a very objective signal and there is little room for interpretation.
Thus, if you are a new trader, looking for a good momentum indicator, I suggest going with the MACD.
Overall, as with most indicators, you probably don’t need it as you can read momentum information directly from your chart. HOWEVER, never let anyone tell you that indicators don’t work. They do! It just comes down to how you use them.
Indicators are great trading tools which offer objective and easily to interpret information. In the case of the MACD, the indicator is ideal when it comes to analyzing momentum and also finding new trends.