MACD – Moving Average Convergence Divergence

The moving average convergence/divergence technical indicator or MACD as it is commonly known is a charting technique developed by Gerald Appel in the late 1970’s. The technique is utilised to attempt to predict changes in trend direction of a market – irrespective if this is a stock, forex pair or index and is one of the simplest and most reliable indicators available.

But how does it work? MACD utilises moving averages, which are essentially lagging indicators, to introduce some trend-following traits. The moving average convergence/divergence technique involves the calculation of two moving averages over different time horizons; with one being slower than the other. These lagging indicators are transformed into a momentum oscillator by deducting the longer moving average from the shorter moving average. The resulting chart outputs a line that oscillates above and below zero, without any upper or lower limits. For example, one may be a moving average of the closing price of a stock on 12 consecutive trading days (the fast moving average), and the other consisting of the moving average over 26 days (the slower moving average). The indicator will then study the difference between the moving averages and then chart a line referred to as the MACD line.

I have found the use of the MACD to be pretty handy over time. Not that I don’t think that the other indicators are no good, as the above tools in my opinion provide just the right amount of information to add further confirmation, to what you would be reading in the chart anyway.

I like to use the MACD to add further confirmation to the RSI. I tend to use them as a pair and one tends to confirm the other. If you have the option with the MACD, look for a setting that will allow you to show the histogram view for this indicator. I feel this provides a great addition to the RSI.

This is how I read the MACD. Basically it provides me an indication of how oversold or overbought a chart may be. For example if the RSI is pointing towards an overbought position, you can look to the MACD to see if this also concurs. The MACD, if using the standard view along with the histogram, will show the histogram as a rising hill reaching the very peak, together with the MACD lines which will begin to converge and cross. If that is happening, then you can look towards that as a confirmation that the stock/chart will be overbought and a subsequent retrace may happen.

The reverse is true for a bounce, where there is an oversold position. Simply the histogram will be like the dip on a big dipper and the lines that overlay it, will beging to converge and cross. In so doing, and providing the RSI is showing an oversold position and it should, then a bounce may ensue.

Some points to remember with indicators -:

Remember, they are not the be all and end all of spotting trades. Many traders pay too much credence on these and many other indicators. All you should use an indicator for, is to use it to add greater weight to a trading decision, nothing more. Your trading decision shouldn’t be made purely on what an indicator is showing you. YOU SHOULD rely more so, on what your own eyes are telling you.

Don’t forget that the largest psychological barrier to traders is support and resistance. If you believe you have found a chart that maybe bouncing, then it goes without saying that it must be near a point of strong support. If it is, and the RSI and MACD and what other indicator you may select to use from the above list is showing, should clarify that it is indeed oversold.

Likewise, if you feel you have found a stock/chart that is overbought and is going to retrace, then you must have a good strong resistance and the indicators above should be clarifying your view to an overbought position.

Now one of the other tools we use that add even more strength to our bow, is the Fibonacci retracement tool, which can be used for bounces as well as retraces. Also, it allows you to confirm points of support and resistance also, more details on this great tool follow.

I shall be going into more detail on bounces, retraces etc. later in this module.

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