In this article:
- MACD and Its Components
- Two Simple Ways of Using MACD
- MACD Continuation Signals
- MACD Histogram
- MACD Divergence
MACD and Its Components
The Moving Average Convergence/Divergence (MACD; pronounced “Mac-Dee”) is a trend-following momentum indicator that shows the relationship between two Exponential Moving Averages (EMAs) of the price of an underlying security. It is a highly effective tool that is capable of providing both continuation and reversal signals, as well as foretelling the price development although it is commonly said to be a “lagging indicator” – we will get to that later in this article.
Fig.1 MACD example
Let’s first examine the four components of MACD – the MACD Line, the Signal Line, the MACD Histogram and the Base Line:
• The MACD Line (i.e. blue line in Fig.1) is calculated by subtracting the 26-period EMA from the 12-period EMA
• The Signal Line (i.e. red line in Fig.1) is the 9-period EMA of the MACD Line
• The MACD Histogram shows the difference between the MACD Line and the Signal Line
• The so-called Base Line is simply the zero level in MACD (i.e. horizontal black line in Fig.1)
Two Simple Ways of Using MACD
The first way to use MACD is to look at whether both the MACD and Signal Line are above or below the Base Line. When both the MACD and Signal Line are above the base line, they are said to be in the bullish territory and it is signalling an intermediate or minor uptrend. Vice versa, when both the MACD and the Signal Line are below the Base Line, they’re said to be in the bearish territory and it is signalling an intermediate or minor downtrend.
Fig.2 USDCAD & MACD
For example, when both MACD and Signal Line were in the bearish territory between August and October 2018 (shown in Fig.2), the USDCAD was simultaneously exhibiting an intermediate bearish trend. When both lines moved into the bullish territory in late October 2018, the pair also began an intermediate bullish trend (shown in Fig.2). But do note that this is a lagging way of using MACD – it does not indicate a reversal in trends in a timely manner.
The second way to use MACD is to identify crossovers between the MACD and Signal Line. When the MACD Line approaches the Signal Line from below and then emerges above the Signal Line, it is said to be a bullish crossover and it is signalling an intermediate or minor bullish trend ahead. Vice versa, when the MACD Line crosses the Signal Line and emerges below it, it is said to be a bearish crossover and it is signalling an intermediate or minor bearish trend ahead.
MACD Continuation Signals
Combining the two simple ways of using MACD, you’re able to identify continuations signals. Continuation signals in MACD occur when the bullish crossover takes place when both the MACD and the Signal Line are in the bullish territory (i.e. above the Base Line), or when bearish crossover takes place when both the MACD and the Signal Line are in the bearish territory (i.e. below the Base Line).
Fig.3 USDCAD continuation pattern
As seen in Fig.3, MACD gave a continuation signal in December 2018 when a bullish crossover took place while both the MACD and Signal Line were in the bullish territory above the Base Line (i.e. indicated by the circle in Fig.3). USDCAD appreciated 340 pips following this continuation signal until MACD gave a reversal signal, which will be discussed later in this article.
MACD Histogram
Besides the MACD continuation pattern, the Histogram is another trend-predicting feature of MACD. As MACD Histogram shows the difference between the MACD Line and the Signal Line, it turns negative (i.e. red) when a bearish crossover takes place and turns positive (i.e. green) when a bullish crossover takes place as seen in Fig.4.
MACD Histogram shows the momentum of the price movement. Four different types or phases of price momentum are shown in Fig.4:
• When the histogram is dark green with each successive interval higher than the previous, the price is gaining bullish momentum
• When the histogram is light green with each successive interval lower than the previous, the price losing bullish momentum, or
• When the histogram is dark red with each successive interval lower than the previous, the price is gaining bearish momentum
• When the histogram is light red with each successive interval higher than the previous, the price is losing bearish momentum
Fig.4 MACD Histogram
The main advantage of using MACD Histogram is that momentum gives quicker signals to future price developments than MACD crossovers due to its trend predicting characteristic. When bullish momentum starts declining and the MACD Histogram turns from dark green to light green, traders can reasonably assume that there is not much room left for any further upside movement before a minor correction sets in. Vice versa, when bearish momentum starts diminishing and the MACD Histogram turns from dark red to light red, traders can reasonably assume that the price will not be declining much further before a temporary rally takes place.
MACD Divergence
The last and perhaps the most powerful signal that MACD can give is a divergence pattern, signalling a primary or intermediate reversal in trends. A divergence pattern occurs when the price is continuing to form higher highs and higher lows, while the MACD Histogram shows a declining bullish momentum. Vice versa, a divergence pattern can also occur when the price is forming lower highs and lower lows, while the MACD Histogram is showing a diminishing bearish momentum.
Fig.5 MACD divergence
Continuing with the USDCAD example, as seen Fig.5, the price continued to form higher highs and higher lows since late-December, while the MACD Histogram was showing a declining bullish momentum. A divergence between price and momentum has taken place and this pattern has a powerful bearish implication for USDCAD. As the result, USDCAD began reversing its intermediate bull trend several days after the divergence pattern showed up and plunged more than 300 pips with an increasing bearish momentum.