Using the MACD
One of the most commonly used indicators in the technical analysis of financial instruments is the MACD, which stands for Moving Average Convergence Divergence. Like other indicators, there are many ways to interpret the MACD in order to create forecasts and signals to trade different financial instruments.
The MACD is calculated by finding the difference between two exponential moving averages (“EMAs”), a short EMA and a long EMA. The difference between these two moving averages changes in response to the price action of a financial instrument. For example, if price is trending upwards, often the difference between the short EMA and long EMA is growing. On the MACD, this is shown by a rising MACD line. If price is trending downwards, this will often be shown on the MACD as a falling MACD line. In addition to the MACD line, a simple moving average of the MACD is often plotted with the indicator as well. This simple moving average is called the signal line.
One of the simplest signals given when using the MACD indicator is the MACD crossing the zero line. When this occurs, the shorter EMA has crossed the longer EMA. Many trend following systems use EMA crosses as entry signals, and this same signal is also present in the MACD. This can be a very reliable way to develop a signal for a trading system. Many hedge funds which use trend following strategies use signals such as these as a basis for their trades.
Another signal that can be used when trading the MACD is a crossover of the simple moving average signal line. When the MACD line crosses its simple moving average, this can be used as an entry signal. This will usually provide a much earlier entry signal in comparison to the cross of the zero line, which can help a trader capture more profits from a trend. However, these signals are often less reliable than zero line crosses, and traders can expect to have more losing trades when using the signal line crossover as a signal.
One final way to use the MACD is through trend line analysis. By drawing trend lines on an MACD indicator, predictions can be made about future trends in the movement of the MACD and also in the price of a financial instrument. Trend lines on the MACD can be used to determine points where the MACD will stop and reverse, providing better entry points for trends in price. The MACD can also be used to find divergence between the movement of the MACD and price. Divergence occurs when the movements of the MACD and price do not follow each other. When this occurs, it can be used to predict the reversal of a trend, providing the trader with an entry point. In my experience, signals based on trend line analysis can be very reliable, but they are difficult to statistically analyze due to the discretionary nature of trend lines.