Supporting Price Analysis With The MACD

Introduction

Moving average convergence divergence (MACD) is a technical indicator that shows the trend and momentum of an asset’s price. It is used to determine the current price trend, its strength, and the probability of a reversal. For a trader, the MACD is especially useful to support one’s price action analysis, especially when it comes to identifying entry and exit points for a trade. The main usefulness of the MACD indicator is showing when the momentum of a trend is strong, and when it is weakening.

In this article, we will show you the components of the MACD indicator and show how you can use it to support your price analysis.

Components of the MACD Indicator

The MACD indicator has four components – the MACD line, a signal line, a histogram, and a 0-line which the MACD line and the signal line oscillate around.

  • The MACD Line

The MACD line is derived from subtracting the 26-period EMA from the 12-period EMA. The 12-period EMA is called the fast EMA, and the 26-period is the slow EMA.

  • Signal line

The signal line is the equivalent of the 9-period EMA. You can use the above EMA formula to determine this.

  • The zero line

Remember, the MACD oscillates between 1 and -1. The zero lines sit between these two extreme values. The zero lines are useful when it comes to determining whether the asset price is bullish or bearish, as we will see later.

  • MACD histogram

The MACD histogram is the difference between the MACD line and the signal line. 

Histogram = MACD line – Signal line

By design, it is meant to be a predictor of an impending crossover between the MACD and the signal line. When the market is on a bullish trend, the histogram turns green and is above the 0-line. In a bearish market, the histogram is red and below the 0-line.

When the MACD line crosses below the signal line, it means that the market is turning bearish and the histogram is negative. Conversely, the histogram is positive when the MACD crosses above the signal line showing that the market is turning into a bullish trend.

Using MACD indicator to show a change in momentum

The MACD indicator is best used to show the change in momentum between buyers and sellers in the market. Combined with price action analysis, you can comfortably identify entry and exit signals. Identifying trade opportunities is primarily based on the crossover between the MACD and signal line and the behaviour of the MACD histogram.

How to identify buying opportunities using the MACD?

When you want to buy an asset, the best period to go long is when the bullish momentum is strong. 

Using the MACD, the bullish momentum is strong when the MACD line crosses above the signal line. Note that both these lines must be rising – the steeper the slope, the stronger the momentum. Also, the wider apart they are, the stronger the momentum of the trend. 

If the market has been on a downtrend, and the MACD line crosses above the signal line, it is an indicator that the bearish trend is coming to an end. This shows that buyers are exerting upward pressure on the price. In this case, you will notice that the histogram is still below the 0-line but starting to contract and moving upwards towards the 0-line.

An ideal buying opportunity presents when the histogram crosses above the 0-line, and the MACD is trending above the 0-line. When the histogram is green and crosses the 0-line, it shows that the bullish momentum is stronger and expanding in the market.

When you notice the MACD and the signal trending closer together above the 0-line, it means that the bullish trend is becoming weaker. This can also be confirmed when the histogram changes colour from green to red. Typically, this would indicate a pullback in the trend.

Conclusion

The MACD is best suited as a tool to support whether you are on the right side of the market and not as a standalone signal generator. It would be best if you combined the MACD with the stochastic oscillator and the EMA technical analyses that we have covered in this series. They will help you to identify high probability trading opportunities with low risk.

For example, if you intend on taking a long position, it is best to identify an uptrend in the price action and find an entry setup such as a pullback.  In this case, your indicators support your entry when: 

  • The price stays above the EMAs 
  • The stochastic oscillator shows that the selling pressure is absorbed, and
  • The MACD above the 0-line with the histogram has turned green.

The more support for your entry, the higher the probability of a successful trade.