Most traders are looking for an edge: a bit of information that allows them to make more profitable trades. Many find it in technical indicators: analysis tools that either singly, or in combination, can signal a good point of entry for a buy or an exit point for taking profits.
Popular indicators include candlesticks, Bollinger Bands, and oscillators like the MACD.
Indicators can be challenging to use and understand. While they can help traders make smarter decisions, it is essential to understand both the benefits and the drawbacks of these tools.
As their names imply, they should serve as indicators, not guarantees of profitability.
So, what is MACD and how can it help inform your trading strategy?
What is MACD?
Invented several decades ago by Gerald Appel, MACD compares the relationship between two moving averages of an underlying asset price — such as a stock or futures contract — over time.
The point where two of the moving averages cross signals a potential buy or sell point.
MACD is primarily used to spot and trade momentum as well as to detect trend reversals. It’s one of the easiest indicators to use.
Note: MACD uses EMAs. An EMA is an exponential moving average (MA) that is weighted more heavily for the most recent data.
How is MACD Calculated?
● The MACD is calculated by subtracting the 26-day EMA from the 12-day EMA.
(Other time periods can be used but the 26-day and 12-day periods are most common.)
The MACD line is also displayed with:
● The signal line (a 9-day EMA of the MACD), which is overlaid on the MACD
● The MACD histogram, which is generated by subtracting the signal line from the MACD. (The histogram can be used to detect imminent crossovers.)
Buy and Sell Signals
Buy or sell signals occur at the points where (a) the MACD crosses above the signal line or (b) the MACD crosses below the signal line. This is also called a “signal line crossover.”
● When the MACD crosses above the signal line it’s considered a bullish crossover
● When it crosses below the signal line, it’s considered a bearish crossover.
The Zero Axis Provides Context
With signal line crossovers, the further above or further below the zero horizontal axis that they occur, the more bullish or bearish (respectively) the signal is considered to be.
But if the crossover occurs near or at the zero horizontal line, it’s considered less indicative of momentum.
What are the Drawbacks of MACD?
MACD is a popular indicator because it is easy to read and gives traders a clear buy or sell signal.
However, like most investment indicators, there are some drawbacks that must be considered.
The biggest drawback of the MACD is that, due to it having some characteristics of a lagging indicator, it can create a large number of false signals when a security whipsaws during an overall trend in rising or falling prices. This can cause a trader to jump too quickly to buy or sell, repeatedly.
Between the commissions and potential trading losses, this can become costly for day traders.
In addition to the constant changes in the signal line, the MACD is an indicator of just one asset. This means you can’t compare two or more assets (such as stocks) to each other to determine which is the better to trade at a given moment.
MACD is an indicator for trading and it works best for momentum trading. Investors looking at the long term will not find this investment indicator useful in choosing the right stocks, ETFs, or commodities to add to a portfolio.
Despite the drawbacks of MACD, many traders rely on the indicator due to its ease of use and clear transaction signals. As a simple and relatively reliable indicator, MACD can be easily incorporated into your trading strategy.
Final Thoughts on MACD and How to Use It
At its core, MACD is a way of analyzing a stock or commodity’s price by looking at several moving averages and how they interact with each other. Based upon these averages, you may be able to predict if the price of a security will rise or fall and adjust your buying or selling strategy accordingly.
However, most successful traders rely on multiple indicators, comparing signals between them, and mixing that information in with fundamental analysis before making a trade.