MACD : Effective Indicator for Technical Analysis

MACD: The Most Effective Indicator for Technical Analysis?

MACD, or Moving Average Convergence Divergence, is a widely used technical analysis tool in the world of trading. While it has its advantages, such as its ability to identify trend changes and momentum shifts, it also has limitations. In this article, we'll explore the pros and cons of using MACD and help you decide if it's the best indicator for your trading strategy.

What is MACD and how does it work?

MACD is a trend-following momentum indicator that uses moving averages to identify changes in trend and momentum.

It consists of two lines: the MACD line and the signal line.

The MACD line is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The signal line is a 9-period EMA of the MACD line. When the MACD line crosses above the signal line, it's a bullish signal, and when it crosses below the signal line, it's a bearish signal. Traders use MACD to identify trend changes, momentum shifts, and potential buy and sell signals.

The MACD is one of the most powerful technical tools in the arsenal of many traders. This indicator is used to verify the strength and direction of a trend, as well as to define reversal points.

 

 MACD stands for Moving Average Convergence Divergence and shows the relationship of the two Moving Averages of the price.

How to implement.

MACD is included in the default MetaTrader indicator kit, so you don't need to download it. Go to "Insert", search for "Indicators" and then "Oscillators" – and you will see the MACD. The indicator will appear in a separate window below the price chart.

 The classic setup includes EMAs of 12 and 26 periods and a signal line (SMA) with a period of 9. You can select other parameters depending on your objectives and trading style. For example, the MACD (5,35,5) is more sensitive and might be better suited for weekly charts.

Increasing the number of periods for the signal line will reduce the number of crossover signals, helping to avoid false signals. However, trading signals will occur later than they would with a shorter EMA signal line.

The indicator can be applied to any temporality, but it is preferable to choose those of H1 and older.

How the indicator works.

The main idea behind the MACD is that it subtracts the longer-term Moving Average from the shorter-term Moving Average. In this way, it turns a trend following indicator into a momentum indicator and combines the characteristics of both.

The MACD has no limits, but it does have a zero mean, around which it tends to oscillate as Moving Averages converge, intersect, and diverge.

Convergence occurs when the Moving Averages move relative to each other. Divergence occurs when the moving averages move away from each other. The MACD histogram is above 0 when the 12-period SMA is above the 26-period SMA and below 0 when the shorter SMA is below the longer SMA. As a result, positive histogram values point to an uptrend, while negative values signify a downtrend. 

How to use.

In general, the market is bullish when the MACD is above 0 and bearish when it is below 0. The MACD provides traders with several types of signals: signal line crossovers, overbought/oversold levels, center line crossovers, as well as divergences.

1. Signal line crossings.

A bullish crossover occurs when the MACD starts to rise and then goes above the signal line. A bearish crossover occurs when the MACD begins to decline and crosses the signal line to the downside.

The MACD works best in trends when the price range is fairly narrow. A good strategy may be to set a trend and then only use MACD signals that are in line with this trend.

In the image below, you can see that in a downtrend it is prudent to only trade negative MACD crossovers with the signal line. 

2. Overbought/Oversold levels

It is also possible to use the MACD as an oscillator. It is common knowledge that the market always goes back to the mean and the fast Moving Average always goes back to being slow. 

The greater the divergence between the Moving Averages (the greater or lesser the MACD histogram), the more bullish or bearish the market is and the greater the probability that the price correction will drive the MACD to zero. As a result, it is possible to trade extreme highs/lows of the MACD as a signal that the market is overbought/oversold.

Since the indicator has no upper or lower bounds, you will have to judge the extremes by visually comparing the MACD levels. Keep in mind that these types of signals require confirmation of price action or other technical indicators. 

3. Zero line crossing.

A bullish zero line crossover occurs when the MACD moves above 0 to turn positive. It can be used as a confirmation of an uptrend. A bearish zero line crossover occurs when the MACD goes below 0 to turn negative. This can be used to confirm a downtrend. Here the MACD gives trading signals similar to a system of two Moving Averages. One of the strategies is to buy when the MACD rises above the zero line (holding the position until the indicator returns below 0) and sell when the MACD crosses below the zero line (and close the trade when the indicator returns to above 0). However, this approach is profitable only when strong trends emerge. During a volatile sideways market, this can result in losing trades.

 

4. Divergences

Also, pay attention to the divergence/convergence between the indicator and the price. Bullish convergence is formed when the price sets lower lows, while the MACD histogram lows rise (buy signal). The bearish divergence is formed when the price rolls over, while the highs of the MACD become lower (sell signal).

Advantages and disadvantages.

One of the biggest advantages of the MACD is that it is both a trend and momentum indicator. However, like all other technical indicators, the MACD is not perfect. Its main flaw is that it gives signals later than the price action itself. Also, the MACD does not provide ready-to-apply Stop Loss or Take Profit levels.

Conclusion.

The MACD is a very useful technical indicator. It produces a variety of signals and can represent a solid foundation of a trading system. To filter out false signals, use the MACD in combination with other technical analysis tools.