The Moving Average Convergence-Divergence (MACD) indicator highlights shifts in the direction of price momentum. That makes it a useful indicator to time trade entries since long traders are more likely to be successful when the momentum is just beginning to turn up, and sell signals should work best when momentum first turns negative.
To find MACD, you begin with two moving averages and subtract the value of the longer moving average from the shorter one. Traders often use 12 days as the value of the short moving average and 26 days for the long average.
The formula for MACD is:
MACD = 12-day EMA - 26-day EMA
It is almost always used with a signal line, which is a 9-day EMA of the MACD line, or as a histogram, which is found by subtracting the value of the signal line from the MACD.
How Traders Use It
MACD can be used to provide very clear buy and sell signals and help takes indecision out of the trading process.
The chart below shows MACD with a signal line in the center of the chart and the MACD histogram below that. Buy signals occur when the MACD line is above the signal line or when the histogram is greater than zero. The opposite conditions define sell signals.
The timing of the signals is the same with either approach. The histogram offers a signal that is easy to spot visually and is preferred by many traders because of that.
Traders can also use MACD to detect divergences. Many believe that momentum leads price, which means momentum will change direction before price. If prices reach a new high while MACD is declining, that sets up a bearish divergence and traders will usually expect prices to decline. If MACD is rising as prices fall, that could be a bullish divergence with prices setting up to turn higher.
Divergences are difficult to interpret. The sell signal in the example is accompanied by a bearish divergence in the histogram. The other price moves are confirmed by momentum, meaning that MACD moves in the same direction as the price.
Why It Matters To Traders
MACD is simple to interpret and it is an effective indicator by itself. Trade signals are precise, which many traders like. Knowing you will buy or sell when the indicator crosses the zero line helps take emotion out of trading. Emotional reactions to the markets can cause large losses or force traders to abandon winning trades too quickly. With MACD, the trade rules are known in advance.
Since momentum is widely believed to lead prices and MACD is one of the simplest momentum indicators, it is a valuable tool for traders wanting to quickly evaluate the trend in momentum. They can then anticipate price moves based on changes in momentum, which they expect to take place first.
(This article originally appeared on ProfitableTrading.com.)