The MACD, what it is and why it ‘works’ for swing traders if allowed to do its job…

Feb 7 • Between the lines • 3196 Views • 11 Comments

shutterstock_123186115As we continue our short series on the most popular indicators swing traders prefer to use, we move onto one of the first indicators novice traders will experiment with – the MACD, or the moving average convergence divergence.

It’s visual simplicity and its ability as a histogram visual to display price action (across many time frames) adds to its inherent appeal. Despite having an attraction to novice traders the indicator is still chosen by many successful and experienced traders to use either as a standalone indicator, or combined with a cluster of other indicators in order to produce a high probability set up alert, once the indicators chosen for the strategy have aligned.

Traders use the MACD as a standalone trading method in a variety of ways. They may wait for the two EMAs that feature as part of the overall indicator to cross, or wait for both EMAs to cross the zero line. In terms of exits many traders dispense with the commonly held belief that “what gets you in also gets you out” as holding onto trades until the MACD reverses sentiment can see the majority of the pip (or points) gained given back to the market unnecessarily. Therefore traders may prefer to use another indicator as the signal to exit, or to set reasonable pip targets based on perhaps the average range of the security over a set period.

We’ll come onto a suggested swing trading strategy at the end of the article, but for now we’ll deal with the science behind the creation of the indicator…

Origins of the MACD

The MACD is a technical analysis indicator created by Gerald Appel in the late 1970s. It is used to spot changes in the strength, direction, momentum, and duration of a trend in a stock’s price.

The MACD is a collection of three signals, calculated from historical price data, most often the closing price. These three signal lines are:

  1. 1.    The MACD line,
  2. 2.    The signal line (or average line),
  3. 3.    The difference (or divergence).

The term “MACD” may be used to refer to the indicator as a whole, or specifically to the MACD line itself. The first line, called the “MACD line”, equals the difference between a “fast” (short period) exponential moving average (EMA), and a “slow” (longer period) EMA. The MACD line is charted over time, along with an EMA of the MACD line, termed the “signal line” or “average line”. The difference (or divergence) between the MACD line and the signal line is shown as a bar graph called the “histogram” time series (which should not be confused with the normal usage of histogram as an approximation of a probability distribution in statistics, the commonality is just in the visualization using a bar graph).

A fast EMA responds more quickly than a slow EMA to recent changes in a stock’s price. By comparing EMAs of different periods, the MACD line can indicate changes in the trend of a stock. By comparing that difference to an average, an analyst can detect subtle shifts in the security’s trend.

Since the MACD is based on moving averages, it is a lagging indicator. However, in this regard the MACD does not lag as much as a basic moving average crossing indicator, since the signal cross can be anticipated by noting the convergence far in advance of the actual crossing. As a metric of price trends, the MACD is less useful for securities that are not trending (trading in a range) or are trading with erratic price action.

Suggested simple swing trading strategy that could also be used as a day trading strategy

In this really simple to follow (and put into practice) strategy we’re using several of the indicators that we refer to in our weekly “is the trend still your friend?” article published each Sunday evening/Monday morning. We’ll use the PSAR, the MACD and the Stochastic lines.

In order to enter, for example, a long trade we’ll be looking for the three indicators to be positive; the PSAR to be below price, the stochastic lines to have crossed and have begun to display tendencies for exiting the oversold territory and the MACD histogram visual to have crossed the median zero line and become positive and be making higher highs if the MACD has lead the other two. Once all three are positive we enter whilst using the low point of the previous day’s candle as an approximate stop, taking consideration to avoid any key looming round, or ‘psychological’ numbers.

We stay with trend (or if in a day trading situation with the daily momentum) until the PSAR reverses trend and signals negative by appearing over price. There are no exceptions. The temptation may be to stay in the trade, but this would be a mistake. However, should price retrace, and then the PSAR once again reverses trend to support the original bullish trend or momentum by re-appearing below price, we are safe to re-enter in our original bullish direction. We also have the advantage of using PSAR to trail price by way of using a dynamic, or fixed trailing stop to ensure we lock in profits. Many traders may prefer to trail by price two days versus one if swing trading. Or by two periods if employing a day trading strategy.

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