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MACD Indicator Profitable Trading Strategies

Introduction

This article will teach you how to read MACD (Moving Average Convergence Divergence), how it is calculated, and profitable trading strategies including bullish and bearish divergence, and histogram analysis.

You will learn:

  1. How MACD is calculated
  2. The MACD Histogram and how to read it
  3. How MACD is useful to profit in any financial market
  4. Bullish and Bearish MACD Divergence

How MACD is calculated

As you can see in the image below, MACD is composed of two lines, the blue (fast line) is called the MACD Line and the red (slow line) is called the Signal Line. The histogram displays the difference between the MACD Line and the Signal Line, so when the lines cross over, the histogram is equal to zero.

What the MACD indicator looks like
Fig. 1 The MACD Indicator

The MACD Line = 12 EMA – 26 EMA

Signal Line = 9 EMA of MACD line

Histogram = MACD line – Signal line

The MACD Line (in blue) is calculated by taking the 12 EMA  (exponential moving average) away from the 26 EMA that are both measured using data from the price chart. The MACD line is faster than the signal line because the signal line is a 9 EMA  of the MACD line.

An EMA (Exponential Moving Average) is a moving average that puts more weight on the most recent data points. ‘An EMA reacts more significantly to recent price changes than a simple moving average (SMA), which applies an equal weight to all observations in the period.’ (Hayes, 2019).

The MACD Histogram and how to read it

The MACD histogram is displayed using vertical bars (see green bars in Fig. 1) that represent the difference between the MACD line and the Signal line. When the histogram crosses the zero line, the MACD lines are crossing. When the faster (blue) MACD line is above the slower (red) signal line, the lines are moving upwards and so the histogram is above the zero line. When the faster (blue) MACD line is below the slower (red) Signal line, the lines are moving downwards, so the histogram is below the zero line.

One of the greatest values of the MACD histogram is given by identifying when the difference between the two lines is increasing or decreasing. If the histogram is well above the zero line, but starts to fall, the uptrend is losing strength. During a downtrend, when the histogram is well below the zero line, but starts to rise, the strength of the downtrend is weakening. 

The histogram turns provide early warnings that can be used to anticipate a reversal in the trend of price. The MACD histogram crossover of its zero line is always preceded by a tun in the histogram towards the zero line (Murphey 1999). For example, as shown in Fig. 2, the entry 1 provided by the higher histogram tick (histogram 2 is higher than 1) is a lower and better price to buy than the entry 2 that is given from the MACD lines crossing. 

A crossover of the MACD lines is always preceded by a turn of the histogram.
Fig. 2 Using the histogram as a tool to enter and exit positions.

However, the histogram turns are best used for exiting already established positions. It is much riskier to enter a position against the trend based on a histogram turn (Murphey 1999). In the example shown in Fig. 2, the exit signal that is provided by the downtick in the MACD histogram (histogram 4 is lower than 3) offers a great place to take profit.

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How MACD is useful to profit in any financial market

The crosser over of the MACD and Signal line is used by many traders as a signal to enter a position. If the MACD line  (blue) crosses downwards below the signal line (red), this is a sell signal (see points 1 and 3 in Fig. 3) and if the MACD line (blue) crosses upwards above the signal line (red), this is a buy signal (see point 2 in Fig. 3). When the MACD lines are well above the zero line, the underlying asset is overbought (see crossover 3) and when the MACD lines are well below zero, the asset is oversold (see crossover 2). The best buy opportunities are when the MACD lines are very low and the best sell opportunities are when the MACD lines are very high.

The MACD line crossover trading strategy.
Fig. 3 The crossover of the MACD lines can be used as a buy or sell signal.

However, in my opinion (having traded using MACD for many years) I believe that using MACD crossovers as a buy or sell signal will offer too many buy and sell signals that will result in losing trades. I do not disregard the signal altogether, but I think it should be a complementary signal to other indicators and not a primary signal to enter trades. For example, if you combine the MACD indicator with RSI, Elliott Wave, Candlesticks, and Volume analysis, your profitability can increase massively. If you want to learn about these indicators, check out the other articles on the BBOD Blog.

A much more profitable way to use MACD as a signal to enter and exit positions is by identifying Bullish or Bearish divergence.

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Bullish and Bearish MACD Divergence

When a divergence on the MACD histogram is seen, it warns of a reversal in the trend, so it offers a great opportunity to make a quick profit and is applicable to any financial asset. 

A Bullish Divergence on the MACD indicator is seen during a down-trending market when the price makes a lower low (4 is lower than 3 in Fig. 4) while the MACD histogram makes a higher low (2 is higher than 1 in Fig. 4). Thus, the MACD is signaling that the price will likely rise. In the example shown below, a good way to signal where to take profit is to wait for the histogram to tick lower, as shown by the profit targets 1 and 2.

MACD Bullish Divergence
Fig. 4 An example of MACD Bullish Divergence

Bearish Divergence is seen during an up-trending market when the price makes a higher high (4 is higher than 3 in Fig. 5) while the MACD histogram peaks made a lower high (2 is lower than 1 in Fig. 5). Once the MACD histogram begins to make a lower tick on the second peak, this can be used as a signal to enter a short position. A method to take profit can be to wait for an upward tick in the MACD histogram as shown in the example below (see ‘take profit’).

Fig. 5 An example of MACD Bearish Divergence

Author: Luca Williams

Conclusion

Please note that you can substantially increase your chances of success if you combine MACD Indicator signals with other forms of technical analysis such as Elliott Waves, RSI, Volume, Moving Averages, Candlestick Reversal Patterns Part 1, Part 2, Part 3.

Please feel free to test your trading strategy on BBOD, the first non-custodial cryptocurrency derivatives trading platform with an unprecedented level of security and transparency. BBOD is to become the most liquid and secure marketplace to trade altcoins with high leverage aiming to list perpetual futures contracts on +50 cryptocurrencies by the end of 2020.

Author: Luca Williams

Disclaimer

This article has been prepared solely for informative purposes and should not be the basis for making investment decisions or be construed as a recommendation to engage in investment transactions or be taken to suggest an investment strategy in respect of any financial instruments or the issuers thereof. BBOD will not be liable whatsoever for any direct or consequential loss arising from the use of this publication/communication or its contents. 

References

  • Hayes, A (Jul 8, 2019) Exponential Moving Average – EMA Definition, Available at: https://www.investopedia.com/terms/e/ema.asp (Accessed: 11th of October 2019).
  • Murphy, J. J. (1999). Technical analysis of the financial markets – A comprehensive guide to trading methods and applications: The New York Institute of Finance
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