Watch our video on how to read macd when trading.
This week I want to present the MACD study. This study will be added to our divergence series. We will discuss the how to read MACD and how it should be used. For other divergence studies, you can check out the RSI Divergence Indicator Study and the OnBalanceVolume Indicator Study.
What is the MACD? It's a “moving average” study that presents “convergence and divergence” signals between the Value Line and the Avg Line. As a result, it's also known as the Moving Average Convergence Divergence.
In the picture below we open the user dialog box for the MACD Study inside ToS and see the signals settings. Let’s take a closer look.
From left to right, we have Value, Avg, and Diff. ZeroLine, UpSignal and DownSignal are also present but we can set them aside for now. To better understand how to read MACD, we need to understand what these things are inside this user dialog box.
Now that we have identified what the names represent, we can begin to decipher how to read MACD and what the moving average convergence divergence signals are made of. As a result, the picture below a candle stick chart shows the 26EMA and 12EMA.
The Value Line in the MACD study is nothing more than the value we get when we subtract the 26EMA from the 12EMA.
The Value Line by it-self does not offer many useful signals. However, one signal it does offer alone is slope or market trend direction. When the Value line is pointed up then the price is in an uptrend. Likewise, if the value line is pointing down then price is in a downtrend.
The steeper the slope on the value line, the stronger the momentum of the trend. Remember that the Value Line is derived from two moving averages.
Just like moving averages, the Value Line Slope can offer some important clues. A sideways Value line is an indication of market uncertainty, consolidation, or “ranging patterns.” Use this as a guide on how to read MACD.
The Avg Line is the Value Line Average. Think on this for a moment. We took the 26EMA value and subtracted the 12EMA value to get the MACD Line.
Now we have the Avg Line which is the average of the MACD Line. Understanding why this is beneficial will help you understand why the MACD study is such a powerful tool; and why you need to know how to read MACD, especially when trading low float stocks.
Averages provide access to the mean. Since NO ONE can predict the market, the best we can do is try to understand what has already happened and try to develop an understanding of what COULD happen next based off the previous data.
An Average of ANYTHING is a great way to visualize where the COMMON ACTION is. To visualize where the “NORMAL” can be found. Once we can identify "normal" we can begin looking for signals that are not normal.
The Diff is presented in the MACD study as a Histogram. The Diff is the measured distance between the Value Line and the Avg Line.
That may sound confusing when learning how to read MACD; however, it really means that instead of presenting Diff as a line (like the Value Line or the Avg Line) the Diff is shown by using Swab Bars.
In the picture above, you can see that when the Value Line converges with the Avg line, the Diff Swabs become shorter. When the Value Line and the Avg Line cross over the Diff Swabs also cross over from one side of the Zero Line to the other side of the Zero Line.
This is because the Diff Line is measuring the distance between the Value Line and the Avg Line. When they are touching (during the cross-over) there is no distance between them to measure.
In a normal MACD study, the Avg Line is set with a default of 9. It is the average of the average convergence or divergence. Perhaps it is time to understand those terms more to better understand how to read MACD.
The MACD line is the measurement between two moving averages, as presented above. When those two moving averages move towards each other, they converge.
We've learned from the Moving Average Blog that when moving averages move towards each other, it is a signal of failing momentum. By measuring this movement towards each other we can develop some analysis on the strength of the trend presented by the sloped Value Line. As a result, we can better understand how to read MACD.
Again, how to read MACD is the measurement between two moving averages. Divergence is when these two moving averages move away from each other. They are diverging.
The signal's given when two moving averages spread out and move away from each other. By performing analysis on this movement, we can measure the strength of the trend presented. This is done by the slope of the Value line.
The Fast Line (shorter moving average or 12EMA) will follow price more closely than the Slow Line (longer moving average, or 26EMA) when price makes a sharp move in direction.
The two moving averages separate because the slower moving average will not follow as quickly. The farther away these two moving averages become, the steeper the slope and the greater the divergence.
What causes the Value Line to cross over the Zero Line? The Moving Averages on the price chart.
Look at the picture above, you can see that when the 12EMA and the 26EMA cross, the Value Line crosses the zero line. In other words, the MACD crosses the Zero Line.
This gives us a great signal of price reversal since we use moving average cross-overs to signal when price has changed direction. Hence the importance of understanding how to read MACD.
Let’s review. When learning how to read MACD the MACD Study shows two lines and a histogram of the distance between those two lines.
The first line is called the Value Line (or the MACD Line). It's the value of the distance between the 26EMA and the 12EMA. This measurement of the convergence and divergence between these two EMA’s is the MACD line or the Value line.
The EMA of the Value Line is called the Avg Line. The Diff Swab is the measurement between the Value Line and the Avg Line. This is also known as the MACD Line and the MACD Average.
The Value Line is a measurement of moving averages on the price chart. The Avg Line and the Diff Swabs are internal indicators and ONLY measure the Value Line. They have nothing to do with price at all. In fact, the Avg Line and the Diff Swabs are an indicator of an indicator.
The MACD is not a “GO / NO GO” study that will offer you trade entries and trade exits. The MACD Study is designed to watch for changes in current market direction. As a result, it gives signals of when the directional momentum is shifting or changing.
That's it; current direction, impending directional change and momentum strength of the current market direction. The Value Line shows direction and the Diff Swabs show momentum.
Hence why knowing how to read MACD is important to trading the indicator.
Now we have a clear understanding of how to read MACD as well as where the signals come from. We may begin developing a few strategies that use these signals.
The different MACD signals are reversals, momentum, and trend. While we'll focus on the signal analysis on the MACD study, this is a great time to point out that no study or indicator should be used alone. All analysis should include support and resistance, volume, and tape.
The MACD may be used to develop a bias in market direction as well as determine the trend. As a result, knowing how to read MACD can help define a trend. One way to do this effectively is to apply the MACD on a higher time frame.
As a result, the trend is determined and then take trades that go with said trend. For example, if you trade on the 4-hour chart you would want to look at the daily chart with the MACD to develop a trend bias.
If you trade on the 1 hour, you would want to set the MACD onto a 4-hour chart to determine market bias. The MACD will show trend bias with the Value Line.
When the Value Line is above the Avg Line then you would look for long trades. However, when the Value Line is below the Avg Line you would look for short trades. Trade with the trend.
The MACD offers a glimpse of changing market trend. If the Value Line is above the Avg Line, long trades should be taken. Let’s look at that more closely.
This indicator has great swings above and below the Zero Line. The Value Line presents more signals than just being above or below the Avg Line. Look at the slope of the Value line and the length of the Diff Swabs.
This allows us to anticipate upcoming trend changes or develop a contrarian perspective. In the picture below, you can see on the daily chart how the Diff Swabs began to print lower and lower as the Value Line curved over and began to converge.
The Avg Line tells a story of impending market trend change. On these types of trading days, it would be good to perhaps avoid trading the stock, use a lower time frame, or anticipate an uncertain market.
As a result of knowing how to read MACD, you have the ability to trade the trend as well as know when to sit out.
If you know how to read MACD then you know it's a great tool to identify when price action is range bound. When looking for an anticipation trade, the MACD can show when volatility is low, when price action is consolidating, and when momentum begins to build for an explosive move out of the contraction.
In the picture below, you can clearly see where the Diff Swabs leveled off and swapped above and below the Zero Line as price ranged in a tight pattern. These signals are very clear and offer an opportunity to anticipate a move before the breakout.
The MACD is a great tool to identify price action divergence just by looking at the trending Value Line and the trending price. However, I still believe that building a divergence signal into the MACD Indicator Study allows the trader an opportunity to focus on other factors.
For instance, instead of continuously seeking divergence between price action and the MACD you're able to wait for a divergence signal that identifies when divergence has occurred.
A beneficial tip; lower timeline charts have a lot of divergence signals that produce few meaningful results. This tip doesn't apply just to the MACD but to all divergence studies in lower timelines.
The MACD Indicator Study that I've coded offers signals of Bearish or Bullish Divergence when price action and the MACD line disagree. You find then when you know how to read MACD. These divergences offer the trader an opportunity to develop a stock trading strategy based on an impending change in trend or momentum.
In the picture below, you see the new MACD Dialog Box with the Bullish and Bearish Divergence user settings. These signals can be turned on or off and show up on the Zero Line when a divergence is detected.
Throughout this article we've discussed how to read MACD as well as divergence, price action, trend direction, and momentum. These common trade tactics are the backbone of a full trading strategy.
It doesn't matter if you're a swing trader, day trader, options trader or even a futures trader; the basic trading tactics discussed in this blog should be familiar to you. Hence the need to understood 100% before taking a trade.
As a member of the Bullish Bears Community you've paid for access to thousands of dollars' worth of education and training. Make sure you're taking advantage of the value you've paid for if you're serious about stock market trading.
The ThinkOrSwim MACD study that I developed can be added by using the Copy / Paste commands. The link is: http://tos.mx/FFw0YX
The MACD is not the tool for entries and exits. I've read a lot of blogs that suggest a crossover is a trade entry signal; however, I disagree.
One of the great things about being an individual trader developing our own skills, abilities and opinions about market analysis and trade strategies. The more we learn and grow into our abilities, the better our analysis becomes.
The reason I don't consider the moving average convergence divergence a trade signal indicator is the same reason that I don't consider a moving average crossover a trade entry signal. The signal is too late and has no context.
Can it be used as a signal for entry? Yes, however there are other tools that were designed to give such signals and do a better job. The MACD was not designed to provide entry signals.
When you first started trading you may have heard that moving average crossovers are a great trade entry signal. A lot of information suggests using the 9EMA and the 20EMA combined or the 8EMA and the 15EMA.
Look back over the charts after the market has closed. Compare the EMA crossovers to the market price action. You may have seen some great opportunities. However, if you tried to trade that strategy in real life, you may have found that there are fake-out signals, failed entries, or changes in direction soon after the crossover.
Using two moving averages as a signal to enter a trade at the crossover is a bad idea. The MACD is nothing more than a measurement of two moving averages. As a result, I'll say it again; the MACD study is not designed to be a trade entry signal.
Learn how to read MACD. The MACD is a great indicator that offers a trader perspective on the direction of the market trend, the strength of that trend and signals of approaching trend changes or failing momentum.
In fact, market Forecasting is a skill that must be developed by study and practice.
Knowing how to read MACD helps you develop that skill. When added to other chart and market analysis, the MACD Indicator Study provides you with the missing pieces of the puzzle.
While we did not review modifications to the MACD user settings, you now have a better understanding of the MACD indicator. As a result, you may begin to research different ways to adapt and develop MACD trading strategies that fit your style.