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Abstract:MACD is an acronym for Moving Average Convergence Divergence.This technical indicator is a tool to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After all, a top priority in trading is able to find a trend, as that is where most money is made.
In a MACD chart, you will see three numbers.
l The first is the number of periods to calculate the faster-moving average.
l The second is the number of periods in the slower moving average.
l The third is the number of bars to calculate the moving average of the differencebetween the faster and slower moving averages.
For example, if you see “12, 26, 9” as the MACD parameters (which is usually the default setting for most charting software), you could interpret them as below:
12 represents the previous 12 bars of the faster moving average.
26 represents the previous 26 bars of the slower moving average.
9 represents the previous 9 bars of the difference between the two moving averages.
This is plotted by vertical lines called a Histogram (the green lines in the chart above). There is a common misconception when it comes to the lines of the MACD. 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, according to our example above, this would be a 9-period moving average, which 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 smooths the original line even more, which gives us a more accurate line.
The Histogram simply plots the difference between the fast and the slow moving average. It may sometimes give you an early sign that a crossover is about to happen. If you look at our original chart, you can see that as the two moving averages separate, the histogram gets bigger.
This is called a MACD divergence because the faster moving average is “diverging” or moving away from the slower moving average. 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. When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
From the chart above, you can see that the fast line crosses under the slow line and correctly identifies a new downtrend. Notice that when the lines cross, the Histogram temporarily disappears. This is due to the difference between the lines at the time of the cross is 0.As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is a good indication of a strong trend. Lets take a look at an example.
In EUR/USD‘s 1-hour chart above, the fast line crosses above the slow line while the histogram disappears. This suggests that the brief downtrend could potentially reverse. EUR/USD begins shooting up as it starts a new uptrend. Imagine if you go long after the crossover, you would’ve gained almost 200 pips! There is one drawback to MACD. Naturally, moving averages tend to LAG behind price. After all, its just an average of historical prices. 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. That means MACD is still one of the most favored tools by many traders.
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The views in this article only represent the author's personal views, and do not constitute investment advice on this platform. This platform does not guarantee the accuracy, completeness and timeliness of the information in the article, and will not be liable for any loss caused by the use of or reliance on the information in the article.