As they say in stock market lingua, the trend is your friend. Catching the market trend is the key to profitable trading. As a retail trader, you are just like a surfer hoping to catch the big wave and ride along with it. This is because you do not have the financial capability to move the market like big players.
Going against the trend is a sure way of losing money in the market very fast. It’s like going against a moving train. One technical tool which you can use to spot trends in the market is the MACD indicator.
When used in combination with other technical indicators, the MACD can be used to identify good entry and exit points, thereby minimizing your risks and increasing your chances of scoring a profitable trade. So let’s know more about the MACD.
What is MACD?
The Moving Average Convergence Divergence (MACD) is a technical indicator that simply measures the relationship of exponential moving averages (EMA) of a security. The indicator was developed in 1979 by Gerald Appel and is one of the most popular technical indicators in trading because of its simplicity and flexibility. As a trend-following momentum indicator, the MACD can be used to ascertain a security’s trend thereby providing trading signals and identifying trading opportunities.
The MACD measures momentum or trend strength by using the MACD line and zero line as reference points. The indicator shows a MACD line (blue), a signal line (red), and a histogram (green), with the MACD line and the signal line separated by a histogram. The MACD indicator displays the differential between two exponentially scaled moving averages of 12 and 26 periods, respectively. The signal line is usually a 9-period exponentially smoothed average of the MACD line.
Although the two lines of the indicator appear to be simple moving averages (SMAs), they are layered exponential moving averages (EMAs). The signal line is the faster line, while the MACD line is the dominant, slower line. Between zero and one, these MACD lines fluctuate. With overbought and oversold signals above and below the zero-line, this has MACD oscillator-like features.
The MACD confirms an uptrend when it trades above the signal line, which traders interpret as a buy signal. On the other side, if the MACD crosses below the signal line, a downtrend is confirmed. This is regarded as a signal to sell.
How is MACD calculated?
MACD is calculated by subtracting the long-term EMA (26 periods) from the short-term EMA (12 periods). An exponential moving average (EMA) is a type of moving average (MA) that places a greater weight and significance on the most recent data points.
The exponential moving average is also referred to as the exponentially weighted moving average. An exponentially weighted moving average reacts more significantly to recent price changes than a simple moving average (SMA), which applies an equal weight to all observations in the period.
How to use the MACD
As a technical indicator, the MACD cannot be used in isolation. This is because MACD is a lagging indicator. This implies that the data used in MACD is based on the historical price action of the stock. Since it is based on historical data, it must necessarily “lag” the price. This lag in price can lead to misreadings and not catch the trend in real time as it is happening.
As such, the MACD should be complemented by using other technical indicators such as the RSI, Parabolic SAR, and Stochastic. They can be combined with support and resistance areas and candlestick chart patterns.
Limitations of MACD
One of the major limitations of the MACD is that it is a lagging indicator. By using historical data to calculate trends, traders may not be able to catch the trend as it is happening. This can lead to flawed signals, prompting traders to ‘mistime’ their entry and exit points thereby leading to losses.
Novice traders may find this indicator difficult to use initially, which is why going through basic moving averages and EMA fundamentals will benefit traders who are looking to make use of the MACD indicator.
Thirdly, the MACD indicator is considered to work best in trending markets. This limits its use for traders depending on their trading strategies. For example, if a market trades flat, or in sharp movements, using the MACD to confirm entry and exit points in such a situation may be futile.
Finally, variations that can be implemented with the MACD indicator are almost infinite which makes it very personal to the trader. Each trader can tweak the indicator to suit his personal preference. This subjective nature of the MACD will mean that results differ from trader to trader which takes away any consistency.
Key takeaway
The MACD is unique in that it serves as an oscillator as well as MACD crossover indicator. This dual purpose enables traders to catch momentum and trends in the market. However, it is best used in combinations with other technical indicators. This is because MACD uses historical data which makes its move lag the real-time action in the marketplace. At best it should be used to confirm trends rather than as a primary indicator used to identify trends.
Photo by Markus Spiske on Unsplash
