Developed by Gerald Appel, this is a very important, and most reliable tool in Technical analysis.
Why should I use it?
Finding out when the previous trend has ended and a new trend has just begun, is one of the most rewarding things you can achieve as a trader.
The MACD indicator can help you do just that. It is an excellent trend indicator which can tell you when a new trend might be forming in its early stages, allowing you to trade in the right direction from the very beginning.
The MACD can also spot clear buy and sell levels using a simple tactic which is called “divergence”. Using Divergence you will find out when the market has reached a possible top (which will signal you to sell) or a possible bottom (which will signal you to buy).
Divergence will be explained step by step in the “how to use” section.
How does it look like?
The MACD is made out of two moving lines:
* The first line is a fast moving line. This is the line which reacts faster to the movement of the market.
* The seconds line is a slow moving line, which is also called the signal line.
How does it work?
The MACD is very easy to work with.
We will start by learning how to spot a change in trend, and then show you how to use the divergence tactic.
Spotting a change in trend (the lines cross-over)
Every time the fast moving line (in this example the blue line) crosses the slow moving line (in this example the red line) from below upwards, this will indicate a new up trend is forming, and consequently a buy signal.
Every time the fast moving line is crossing the slow moving line from above downwards, this will indicate a new down trend is forming, and consequently a sell signal.
So we know that when the fast line is crossing the slow line, it will tell us in which direction the new trend is headed, but in order for the signal to be more reliable the cross-over of the fast line over the slow line should be at the extreme levels of the MACD.
What do we mean by that?
In an Extreme level the cross over is done far away from the center of the MACD indicator box. (far away from the value; zero, of the MACD), this means the crossover is taking place around the top or around the bottom of the MACD indicator box.
For example, if the fast line is crossing the slow line from below up – indicating a possible up trend, but it does so in the middle of the MACD indicator box, this will not be a reliable buy signal.
However, if the fast line is crossing the slow line from below up, and it does so on a much lower level of the MACD zero value ( at the bottom of the MACD box), this will be a reliable buy signal, since the lower the cross-over between the fast and the slow lines, the more oversold the market is at the time of the signal – rising its probability to be valid.
This works just the same for the down trend, if the fast line is crossing the slow line from above downward – indicating the beginning of a down trend, it will be more reliable if the cross-over took place much above the zero value of the MACD (on the top of the indicator box), since the higher the crossover, the more overbought the market is at the time of the signal.
Divergence – finding possible tops and bottoms
Divergence is spotted every time the market is making a higher high, or a lower low, while the MACD is making a lower high or a higher low – not following the market’s action.
A possible bottom is spotted when the market is making a low, and then a lower low, but the MACD is responding by making a low, and then a higher low, creating what is called a positive divergence – which is a buy signal.
A possible top is spotted when the market is making a high, and then a higher high, but the MACD is responding by making a high and then a lower high, creating what is called a negative divergence – which is a sell signal.
Confused? take one look at the example below, it will surly make things much clearer.
Above you can see how to spot a new trend when the fast MACD line (blue) is crossing the slow MACD line (red). First the fast line crosses the slow line from above downwards-signaling a sell. Then at 20:30, the fast line crosses above the slow line, signaling a buy.
Above you can see how a divergence is formed – First the market creates a low on Dec 3, and then a lower low on Dec 4, while the MACD is creating a low on Dec 3 and a higher low on Dec 4, therefore signaling you to buy.