We have learned that moving averages can be used to visually detect changes in trends. Often more reliable than powerful trendlines (remember that one should work with both indicators). But we can remain cautious about this story angle between different MM (moving averages), and start learning about the MACD.
So you need a tool that helps visualize this crossover and even tries to detect a change even earlier than the other indicators. You need to be ready!
This trading indicator is called MACD, an abbreviation for Moving Average Convergence Divergence by Gerald Appel, publisher of "Systems and Forecasts". Let's go to the IBM title of which you know the detection tips by trendlines and moving averages. Let's talk about it now in terms of "MACD".
This indicator gives you the best from both, “trend following” (exactly like the moving averages) and “momentum” (strength in which that trend is working at).
The MACD revolves around the value zero. And Traders interpret different signals as soon as the MACD crosses the signal line (an EMA based on 9 days). When that happens, the trend is due a change in direction and you can prepare your fingertips to place a trade.
Calculation
The MACD is simply the difference between two Exponential Moving Averages of different periods. The periods of 12 and 26 days are commonly used for these MMEs (E for Exponential). In the figure, the MACD is placed under the graph. It is drawn in purple and thus reflects the difference of an Exponential Mobile Average over 12 days with another of 26days. Long-term averages can also be useful depending on your trading strategy. There is also a second curve (in orange), which is the MACD signal which is simply an exponential 9-period moving average of the MACD. We will use the Signal Line as a baseline to identify movements. Under the MACD indicator, we added a histogram of it to have another vision. This histogram that displays the difference between the MACD and its signal curve allows two things. On the one hand, it materializes the amplitude of the gap between the two curves. On the other hand, it clearly materializes the crossings. When the histogram is creating bars above zero, the MACD is above its signal and when the bars are below it, it is the opposite. Why do we use Moving Averages that are Exponential instead of Simple? To give more importance to recent prices in the curve, so that it gives us a more responsive dynamism to changes. If you have no idea what I am talking about and you do not remember the difference between Simple and Exponential moving averages, please click here).How do we use the MACD?
The goal that investors have in mind when they set up the MACD is the following. The inventor wants to visualize the points where the MACD cuts its signal line, the MME9. When it goes above the signal line, we have a buy trade signal. In the example, point 1 shows you this crossing of the purple line (MACD) with the orange (MME9). If you use the indicator only in its traditional use, you should buy the value at that time.
The same way it works in the opposite direction. It shows a point of sale. The chart also shows breakthroughs of the MME9 by the MACD, which indicates selling the value. In this case, IBM tends to fall in a so-called consolidation phase.
Here's what makes the MACD so successful.
The signal arrives even earlier than the crossover detection of the MMA20 and MMA50 (moving averages) from the last lesson. But this also makes it dangerous, because remember that the earlier an indicator indicates when to buy or sell, the more likely it is to error. It is, therefore, necessary to work with other tools to confirm its validity.
We also note that the further the MACD moves away from its signal line, the stronger the current trend. Which means that if you are up on the value since crossing at point 1, you can let it run, even if a hesitation momentarily forms in the trend.
We will use the complete opposite to discern a new change in Trend. The closer together the lines come, the more likely it is to change. That is to say that when the MACD will get closer to its signal line, it is that there is a tilt preparing.
Change on trend.
On November 6th and 20th, the reconciliation of the MACD with its signal line (the lines getting closer together) warns us that there might be a next change of trend. In our case, the change is exactly at the beginning of December, at point 2. The MACD has changed direction more clearly, gets closer to its signal line during several sessions and ultimately cuts off its signal line. Better to get out of the trade quickly before burning the profit gained. Analysts have added a small rule for the crossing to be 100% valid. When the MACD crosses its signal line, it will return only if the MACD and the signal have been on the same side for a minimum of 14 sessions that are counted on the day of the crossing. This minimum makes it possible to ensure that one is in a sufficiently stable situation so that the crossing of the MACD with its signal line makes sense and will last. Our case only counts 8 bars going up from point 1 to the left. It is not valid in principle! However, the bullish rally was still spectacular.Other indicators must confirm the MACD.
If we refer to Lesson 1 on trendlines, the break in the resistance shown in the figure is a good indicator. It is though, too late as to be an indicator for the continuation of the rise. The crossing of moving averages (Lesson 2) comes earlier and confirms the probability of a rise. We should always look for at least 3 indicators coming together.- Resistance Break (main trendlines). A bit too late to ride the whole uptrend.
- If we were looking at the moving Averages, we would also see them crossing, on a Golden Cross. But again, just as the trend was taking form.
- Due to the MACD we can see that this trend (proven right by the two indicators above) is forming.
Author: Richard Perry
I have been trading forex for a long time for myself.
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