Chart 101: Understanding the MACD

MACD is an acronym for Moving Average Convergence Divergence.

The MACD indicator is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After all, our top priority in trading is being able to find a trend, because that is where the most money is made.

With a MACD chart, you will usually see three numbers that are used for its settings.

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  1. The first is the number of periods that is used to calculate the faster-moving average.
  2. The second is the number of periods that is used in the slower moving average.
  3. And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the difference between two moving averages.

In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages.

The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average. This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average.

This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average.

Looking at the chart, you will see that as the two moving averages separate, the histogram gets bigger. This is called divergence. As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.

 

How to Trade Using MACD

Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.

1 When a new uptrend occurs, the fast line will react first and eventually cross above the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new uptrend has formed.

2 The instance is the same for a downtrend only that the fast line crosses below the slow line, and after a divergence is a confirmed downtrend formation.

 

Conclusion

Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, MACD is still one of the most favored tools by many traders.

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