Do you understanding the indicators you use for trading? It confuses me that the majority of traders use indicators like the RSI, Moving Averages, ADX, and the MACD, but don't even understand what they are looking at. Knowing is the difference between nailing a trade, or misinterpreting the indications these tools provide. This site is here to show you what your indicators are trying to tell you, and how to use them to benefit your trading account.
Dual Indicator
The Moving Average Convergence Divergence (MACD) displays two primary indications. It displays momentum, and trend-tracing data about trend direction and whether a trend may possibly be over.
Most traders don’t really understand what the MACD is, aside from some bars that go up and down and some lines that somehow move with it. At the core, the MACD is nothing more than a 12 and a 26 exponential moving average (EMA). The bars (or Histogram) displayed within the MACD are calculated by analyzing the EMAs as you'll see in a minute.
The chart below shows the 12 and 26 EMAs on GLD. The 12 moves faster and reacts quicker to price action, while the 26 reacts slower.
Momentum Indicator
The bars themselves, as well as their change in size indicate momentum. When the bars on the histogram are becoming larger, momentum is increasing, meaning the trend is getting stronger. The histogram is nothing more than the space between the 12 and 26 EMAs. That's right. If you laid the 26 EMA flat, the histogram would represent the movement of the 12 EMA.
The letters below represent locations on the chart above:
A. The price is dropping. The 12 EMA is reacting faster with price action and is moving further away from the 26. The distance between the 2 EMAs getting bigger, represented in the histogram becoming larger to the downside, indicating growing bearish momentum.
B. The price turns and begins to increase. The 12 EMA is moving closer to the 26. As a result, the histogram becomes smaller as well. The bearish momentum is fading.
C. The price moves up quick and the 12 EMA is following faster than the 26. Again, the distance between the two is getting bigger, resulting in the histogram increasing in size to the upside. This is an indication that bullish momentum is growing.
When the histogram moves, momentum is moving with it. The direction and angle of the histogram provides data about the slope of the EMAs, regardless whether the bars are negative or positive.
A positive MACD displays the 12 EMA above the 26, while a negative MACD displays the 12 below the 26. As a result, when the 12 and the 26 cross, the MACD crosses over from positive to negative.
Divergences
Divergences can indicate when a trend is over and help you recognize the right time to take profits. A divergence is also capable of providing you with an early entry signal in the opposite direction.
A divergence is kind of like a discrepancy between the chart and indicator. In this case, its when the price action points one direction while the MACD lines point in the other. I've pulled the hourly chart for NK to give a good example of a divergence here.
Now had you been considering a trade in NK, seeing this bullish divergence (to the upside) would be an indication to enter a long trade. If you were following the divergence, and noticed the histogram growing to the upside, it would be even more a entry signal.
Conclusion
As usual, I have to reiterate that using only one indicator (such as the MACD) to generate trade signals will likely not provide the results you're looking for. Understanding several indicators and using them with eachother will help to confirm trade indications. Adding the MACD to your indicators and understanding how to use it correctly can substantially increase your ability to trade effectively.
If found this information useful, then check out Getting the Most from RSI and Moving Averages Explained for other in-depth how-to-use guides. What's your favorite indicator or tool to use while trading? Leave a comment and I may just write about it next.
Thanks for reading.
Labels: Technical Analysis
