Ways to use MACD

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How to Use the MACD Indicator

MACD is an acronym for Moving Average Convergence Divergence.

This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish.

With an MACD chart, you will usually see three numbers that are used for its settings.

  • The first is the number of periods that is used to calculate the faster-moving average.
  • The second is the number of periods that is used in the slower moving average.
  • And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
  • The 12 represents the previous 12 bars of the faster moving average.
  • The 26 represents the previous 26 bars of the slower moving average.
  • The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the green lines in the chart above).

There is a common misconception when it comes to the lines of the MACD.

The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.

In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages.

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average.

This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average.

If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.

This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average.

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As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.

And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!

Ok, so now you know what MACD does. Now we’ll show you what MACD can do for YOU.

How to Trade Using MACD

Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.

When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend.

This is because the difference between the lines at the time of the cross is 0.

As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.

Let’s take a look at an example.

In EUR/USD’s 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend would eventually reverse.

There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it’s just an average of historical prices.

Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, MACD is still one of the most favored tools by many traders.

4 Ways to Use MACD Momentum Indicator During Market Weakness

5 minute, 45 second read

On Friday, the yield curve inverted for the first time since 2007.

This is a time-tested recession warning. It’s also a signal that the bear market is near.

But the Federal Reserve put us on this path more than a year ago.

I highlighted the Fed’s problem in December 2020. That means the invested yield curve isn’t a surprise. And the upcoming bear market shouldn’t surprise anyone either.

Another time-tested indicator is pointing to a stock market decline right now.

In 1687, Sir Isaac Newton described momentum as a fundamental part of the physical world.

Newton’s first law of motion says: “An object at rest stays at rest. And an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force.”

This law explains the trajectory of a golf ball. It also explains many stock market moves. That’s because market analysts closely follow momentum.

There are dozens, if not hundreds, of technical indicators designed to measure momentum. These include popular technical indicators like the Relative Strength Index and the Moving Average Convergence Divergence (MACD).

Newton’s first law inspired the interpretation of these indicators. Prices continue moving in the same direction until some outside force creates an imbalance.

That force is almost always something that changes how investors feel about prices. It could be a bad earnings report or an announcement from the Federal Reserve.

But momentum indicators don’t seem to work for many investors.

That’s because they look at momentum indicators based on short-term data. Instead, they should consider momentum of long-term data.

When investors are bullish, they buy. When they’re bearish, they sell.

Momentum indicators directly reflect sentiment. The more bullish investors are, the more urgently they buy. That makes momentum indicators rise.

As bullishness wanes, the pace of price gains slows. Momentum indicators reflect this price action.

The trend remains up until investors start selling. The decision to sell requires a shift from bullishness to bearishness.

But shifts in sentiment, for groups of investors, tend to be slow.

A Simple View of Momentum

MACD is one of the most popular momentum indicators.

It uses two moving averages. That’s the “MA” in the name.

The indicator is the distance between the two averages. When they converge or diverge — the “CD” in the name — MACD offers buy and sell signals.

Because sentiment causes momentum, many investors are using MACD wrong.

They look at daily or weekly charts. But momentum shifts gradually, so investors should use monthly charts.

Short-term traders rely on short-term charts, but long-term investors should ignore day-to-day market moves.

The chart below shows MACD for the S&P 500 Index with monthly data.

Red areas highlight times when MACD was bearish. These periods aren’t all bear markets. But these periods all coincide with market weakness or pullbacks.

How Effective Is Monthly Momentum?

Visually, this chart offers a great investment strategy: Simply get out of stocks when monthly MACD is bearish.

We can test that idea.

Over the past 20 years, selling all stocks and holding cash when MACD was bearish would have beaten the market. Tested on the S&P 500, the strategy gained an average of 4.7% a year while the index gained 4.4%.

Best of all, risk fell by more than 76%.

The largest loss over the past 20 years for a buy-and-hold investor was 55%. The MACD strategy’s largest loss was 12.8%.

Using the entire history of the S&P 500 back to January 1928, the buy-and-hold investor fared better, gaining an average of 8.6% compared to 6.3% for the MACD strategy. MACD reduced risk by 69% in that test.

Overall, the test results are impressive. MACD avoids large losses.

Bear markets are life-changing. Losses of more than 50% can lead to delays in retirement. With smaller losses, MACD can ensure you meet your financial goals.

This strategy moves to a cash position when monthly MACD is bearish. This might not be possible for all investors. Fortunately, there are alternatives.

You Can Always Act When Momentum Is Bearish

Instead of going to cash, investors could simply stop buying.

That means they avoid adding to positions until MACD turns bullish. Cash builds up in the account. It’s invested only on the next buy signal.

That simple strategy, called “Don’t Buy in a Bear Market,” increases wealth because you should end up investing closer to the bottom. The same amount of money buys more shares at a lower price.

More aggressive investors can add short positions. Shorts increase in value when prices fall. Individuals should probably never directly short the market.

A short sale means you borrow shares from your broker and repay that loan later. There are costs to borrow shares, and the costs often rise in bear markets. Costs alone could eat up the gains.

There is also the risk a large rally can cause losses. In theory, losses on short trades are unlimited. In general, only investment professionals use this strategy.

Instead, individuals can benefit from price declines with inverse ETFs.

Inverse ETFs are exchange-traded funds that increase in value when the index they track goes down. By moving inverse to the index, these funds lose money when the index rises.

Examples of inverse ETFs include ProShares Short S&P500 (NYSE: SH) and ProShares UltraShort S&P500 (NYSE: SDS).

Day to day, SH should move as much as the SPDR S&P 500 ETF (NYSE: SPY) in percentage terms but in the opposite direction.

An UltraShort fund like SDS should move twice as much as SPY in percentage terms but in the opposite direction.

All ETFs are rebalanced daily. Over two days or more, the relationship between the ETFs and index varies. This means they can deliver bear market gains but may not be the right choice for the long-term investor.

There’s a Better Way to Invest During Bear Markets

Put options are the best bear market investment.

Put options give the buyer the right to sell 100 shares of a stock or ETF at a certain price before a specified time.

They generally cost about 2% to 3% the price of the stock. This means they can deliver large gains when markets make small moves.

Options are short-term trading tools. So, investors should take profits from time to time in a bear market.

It also means they can open new trades at a low cost. That keeps risks small.

And with put options, you can never lose more than your initial investment.

Right now, monthly MACD is bearish. In the past, this was bad for stocks.

A put option on SPY is an ideal trade for long-term investors and short-term traders right now.

And I’ll continue to keep you updated on how the latest developments regarding the yield curve will affect your investments.

Michael Carr, CMT, CFTe

Editor, Peak Velocity Trader

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The MACD indicator – How To Use The MACD Correctly

The MACD indicator – How To Use The MACD Correctly

The MACD is a popular momentum and trend-following indicator that is based on the information of moving averages and, thus, ideal to act as an additional momentum tool and momentum filter for your trading. In this article, we will explain what the MACD indicator does, how it helps you analyze price and how to use it in your own trading.

First, let’s take a look at the individual components of the MACD indicator:

MACD Line: The MACD line is the heart of the indicator and by default it’s the difference between the 12-period EMA and the 26-period EMA. This means that the MACD line is basically a complete moving average crossover system by itself.

Signal Line: The Signal line is the 9-period EMA of MACD Line

MACD Histogram: MACD Line – Signal Line

In this article, we focus on the MACD and the signal line in particular. The histogram is derived from the other two components of the MACD and, thus, don’t add as much explanatory value to overall MACD trading.

The basics of the MACD indicator

As I said, the MACD is based on moving averages ad this means that it’s ideal for analyzing momentum, finding trend-following entries and staying in trends until momentum is dying off.

There are 2 MACD signals in particular that we will explore in this article and explain step by step how to use the MACD to find trades:

1) The MACD Line cross 0

Besides the MAXD lines, I also plotted the two moving averages on the charts and it becomes obvious immediately how the MACD works.

When the two MAs cross, the MACD line crosses below 0 as well. As В I said above, the MACD is thus its own moving average crossover system in just one line.

As we know from our moving averages article, a cross of 2 MAs shows a change in momentum and it can often foreshadow the creation of a new trend. So, whenever the MACD Line crosses 0, it shows that momentum is changing and potentially a new trend is just being created.

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1) The Signal Line

When you see the two MACD indicator lines move away from each other, it means that momentum is increasing and the trend is getting stronger. When the two lines are coming closer to each other, it shows that price is losing strength.

However, the MACD is an oscillator and during very strong trends, it won’t give very accurate information. Thus, when you are in a strong trend, don’t get confused by too many crossings of the MACD lines.

TIP: As long as the MACD lines are above 0 and price is above the 12 and 26 EMAs, the trend is still going on.

Trend-following entry

During ranges, the two lines from your MACD are very close together and they hover around 0; this means that there is no momentum and no strength.

At point #1, the price also formed a narrow range and when the price breaks out, the two indicator lines pull away from the 0 line and also separate each other. Then, during a trend, the moving averages can act as support and resistance and stay you in trends as the phase #2 and #4 show – the price never broke the moving averages.

During a consolidation like in point #3, the MACD contracts sharply as well and traders wait for the breakout of the wedge to signal a new trend.

The divergence at#5 is a signal we will explore below and it predicted the reversal. During the downtrend #6, the price then again stayed below the moving averages while the MACD lines stay below 0.

MACD divergences as early entries

MACD divergences are another great way to analyze price and find early trend-following trades.

You can see in the screenshot below how theВ price was moving higher very slowly over a long period of time. At the same time, the MACD moved lower showing that there was no buying strength behind the slow grind. Then, suddenly, price broke below the two moving averages with stronger which happened while the MACD lines crossed below 0 and also separated further. This can be the signal of a new strong downtrend.

Overall, as with most indicators, you probably don’t need them when you can read momentum information directly from your chart. But indicators can be great tools for building confluence and also to create more objectivity in your trading.

HOWEVER, never let anyone tell you that indicators don’t work. They do! It just comes down to how you use them.

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