Are you an indicator trader? If yes, then you will enjoy reading about one of the most widely used trading tools – the moving average convergence divergence (MACD). Today, we will cover 5 trading strategies using the indicator and how you can implement these methodologies within your own trading systems.
What is the MACD?
The moving average convergence divergence calculation is a lagging indicator, used to follow trends. It consists of two exponential moving averages and a histogram as shown in the image below:
The default values for the indicator are 12,26,9.
It is important to mention that many traders confuse the two lines in the indicator with simple moving averages.
The slower line of the moving average convergence divergence is calculated by placing a 12-period EMA on the price and then smoothing the result by another 26-period EMA. The second line is calculated by smoothing the first line by a 9-period EMA. Thus, the second line is faster and hence is the “signal” line.
The last component of the indicator is the histogram, which displays the difference between the two MAs of the indicator. Thus, the histogram gives a positive value when the fast line crosses above the slow line and negative when the fast crosses below the long.
What signals are provided by the MACD?
- Moving Average cross
The most important signal of the moving average convergence divergence is when the faster MA breaks the slower one. This gives us a signal that a trend might be emerging in the direction of the cross. Thus, traders often use this signal to enter new trades.
MACD also gives divergence signals. For example, if you see the price increasing and the indicator recording lower tops or bottoms, then you have a bearish divergence. Conversely, you have a bullish divergence when the price drops and the moving average convergence divergence produces higher tops or bottoms.
- Distance between MAs (overbought/oversold)
Since the indicator has no limit, many traders do not think of using the tool as an overbought/oversold indicator.
To identify when a stock has entered an overbought/oversold territory, look for a large distance between the fast and slow lines of the indicator. The easiest way to identify this divergence is by looking at the height of the histograms on the chart.
This divergence often leads to sharp rallies counter to the primary trend. These signals are visible on the chart as the cross made by the fast line will look like a teacup formation on the indicator.
5 Trading Strategies Using the MACD:
#1 - MACD + Relative Vigor Index
The basic idea behind combining these two tools is to match crossovers. In other words, if one of the indicators has a cross, we wait for a cross in the same direction by the other one. If this happens, we buy or sell the equity and hold our position until the moving average convergence divergence gives us signal to close the position. The below image illustrates this strategy:
This is the 60-minute chart of Citigroup from Dec 4-18, 2015. It shows two short and one long positions, which are opened after a crossover from the MACD and the RVI. These crossovers are highlighted with the green circles. Please note that the red circles on the MACD highlight where the position should have been closed. From these three positions, we gained a profit of $3.86 per share.
#2 - MACD + Money Flow Index
In this strategy, we will combine the crossover of the MACD with overbought/oversold signals produced by the money flow index (MFI). When the MFI gives us a signal for an overbought stock, we will wait for a bearish cross of the MACD lines. If this happens, we go short. It acts the same way in the opposite direction – oversold MFI reading and a bullish cross of the MACD lines generates a long signal.
Therefore, we stay with our position until the signal line of the MACD breaks the slower MA in the opposite direction. The below image illustrates this strategy:
This is the 10-minute chart of Bank of America from Oct 14-16, 2015. The first green circle highlights the moment when the MFI is signaling that BAC is oversold. 30 minutes later, the MACD has a bullish signal and we open our long position at the green circle highlighted on the MACD.
We hold our position until the MACD lines cross in a bearish direction as shown in the red circle on the MACD. This position brought us gains equal to $0.60 (60 cents) per share for about 6 hours of work.
#3 - MACD + TEMA
Here we will use the MACD indicator formula with the 50-period Triple Exponential Moving Average Index. We attempt to match an MACD crossover with a break of the price through the TEMA.
We will exit our positions whenever we receive contrary signals from both indicators. Although TEMA produces many signals, we use the moving average convergence divergence to filter these down to the ones with the highest probability of success. The image below gives an example of a successful MACD + TEMA signal:
This is the 10-minute chart of Twitter from Oct 30 – Nov 3, 2015. In the first green circle we have the moment when the price switches above the 50-period TEMA. The second green circle shows when the bullish TEMA signal is confirmed by the MACD. This is when we open our long position. The price goes up and in about 5 hours we get our first closing signal from the MACD. 20 minutes later, the price of Twitter breaks the 50-period TEMA in a bearish direction and we close our long position. This trade brought us a total profit of $0.75 (75 cents) per share.
#4 - MACD + TRIX indicator
This time, we are going to match crossovers of the moving average convergence divergence formula and when the TRIX indicator crosses the zero level. When we match these two signals, we will enter the market and await the stock price to start trending.
This strategy gives us two options for exiting the market, which we will now highlight:
- Exiting the market when the MACD makes a cross in the opposite direction
This is the tighter and more secure exit strategy. We exit the market right after the MACD signal line breaks the slower MA in the opposite direction.
- Exiting the market after the MACD makes a cross, followed by the TRIX breaking the zero line
This is the looser exit strategy. It is riskier, because in case of a change in the equity’s direction, we will be in the market until the zero line of the TRIX is broken. Since the TRIX is a lagging indicator, it might take a while until this happens.
At the end of the day, your trading style will determine which option best meets your requirements. Now look at this example, where I show the two cases:
This is the 30-minute chart of eBay from Oct 28 – Nov 10, 2015. The first green circle shows our first long signal, which comes from the MACD. The second green circle highlights when the TRIX breaks zero and we enter a long position.
The two red circles show the contrary signals from each indicator. Note that in the first case, the moving average convergence divergence gives us the option for an early exit, while in the second case, the TRIX keeps us in our position. Using the first exit strategy, we generate a profit of $0.50 (50 cents), while the alternative approach brought us $0.75 (75 cents) per share.
#5 - MACD + Awesome Oscillator
This strategy requires the assistance of the well-known Awesome Oscillator (AO). We will both enter and exit the market only when we receive a signal from the MACD, confirmed by a signal from the AO.
The challenging part of this strategy is that very often we will receive only one signal for entry or exit, but not a confirming signal. Have a look at the example below:
This is the 60-minute chart of Boeing from Jun 29 – Jul 22, 2015. The two green circles give us the signals we need to open a long position. After going long, the awesome oscillator suddenly gives us a contrary signal.
Yet, the moving average convergence divergence does not produce a bearish crossover, so we stay with our long position. The first red circle highlights when the MACD has a bearish signal. The second red circle highlights the bearish signal generated by the AO and we close our long position.
Furthermore, notice that during our long position, the moving average convergence divergence gives us bearish signals a few times. Yet, we hold the long position since the AO is pretty strong. This long position brought us a profit of $6.18 per share.
I prefer combining my MACD indicator with the Relative Vigor Index or with the Awesome Oscillator. The reason is that the RVI and the AO do not diverge from the moving average convergence divergence much and they follow its move.
For this reason, the RVI and the AO are less likely to confuse you and at the same time, provide the necessary confirmation to enter, hold or exit a position.
The TEMA also falls in this category, but I believe the TEMA could get you out of the market too early and you could miss extra profits.
Regrettably, I find the MACD + TRIX indicator strategy too risky. Yet, it could be suitable for looser trading styles.
All things considered, the Money Flow index + MACD generates many fake signals, which we clearly want to avoid.
- Moving Average Convergence Divergence (MACD) is a lagging indicator
- The indicator is used to find new trends and to signal the end of a trend
- The indicator consists of three components:
- Faster Moving Average (Signal Line)
- Slower Moving Average
- MACD Histogram
- The moving average convergence divergence provides three basic signals:
- Moving Average Crossover
- Overbought/Oversold Signals
- MACD works with the following indicators:
- Relative Vigor Index (RVI)
- Money Flow Index (MF)
- Triple Exponential Moving Average (TEMA)
- Awesome Oscillator (AO)
- The indicators best suited for the moving average convergence divergence indicator are the RVI and AO.
- External Link - create the moving average convergence divergence formula in excel. This one is for all you book worms that need to see exactly how the indicator works.