MACD is an acronym for Moving Average Convergence/Divergence. It is used in several different ways in various trading methods. I have know more than one trader that used it as a single trading indicator.
The MACD line (the solid magenta line shown on the chart displayed in Figure 1) is a plot of the difference between a 26 bar and a 12 bar exponential moving average. The white line is a 9 bar plot of an exponential moving average of the MACD, often referred to as the signal line. Traditional use of the MACD usually involves trading when the MACD crosses its signal line, crosses the zero value line, or converges or diverges with price.
Over a long time of empirical analysis I have determined that a slight variation on the above numbers provide better results for my short term trading method.
The values I use are as follows: 28 rather than 26, 14 rather than 12 and 7 rather than 9. In essence I use slightly longer moving averages to compute the MACD, but a slightly faster moving average to plot it.
My method of interpretation is also is a bit different – I am interested in MACD line’s convergence and divergence with its signal line – in particular the exact bar on which the convergence or convergence begins.. Because the two lines track very close together much of the time, I use the histogram plot of that difference – shown as the vertical red and green bars on the chart in Figure 1.
The green bars represent positive values and the red bars represent negative values. But we are most interested in the “peaks” of the green bars and “valleys” of the red bars of the histogram. A green peak or a red valley is created by three bars – the middle bar being of greater amplitude than the bar on either side – amplitude being measured from the zero line.
The histogram is plotted as an overlay on the MACD to make the bars appear with more amplitude – since we are only interested in the relative amplitude of adjacent bars.
What we are trying to detect is a change in trend for the time frame in which we are working.
In short term trading, things often happen very fast. In order for a trend direction to change, moving averages must start changing – and the histogram peaks and valleys mark the point that moving averages start to change. It is an early warning that price direction may be about to reverse.
We have marked most of the significant peaks and valleys on the chart shown in Figure 1 with a dotted white vertical line. It is easy to see that in most cases the dotted vertical line also marks a change in price direction.
NOTE: Please ignore the third white dotted line from the left on the chart in Figure 1 – I inadvertently placed it there and just noticed it as of this writing.- it does not mark a peak.
Short term trading is all about price oscillations – and finding a tradable oscillation that is just beginning.
It should not be hard to understand from this simple explanation why the MACD – in the histogram form – makes up very a valuable part of our technical indicator system.
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