MACD Trading Strategy: The MACD Indicator

Introduction on How to Use the MACD Indicator

Traders rely heavily on indicators to assist them with their technical analysis and the variables used to calculate an indicators values are mostly based on the open, high, low, close and volume of a candle/bar.

So many variables have led to the creation of thousands of indicators but they all fall into 4 types or categories which aim to achieve one particular goal:

1. Trend Indicators
2. Momentum Indicators
3. Volatility Indicators
4. Volume Indicators

Beginner traders often make the mistake in thinking that the more indicators they have the better their results would be but this is not the case. Using too many indicators, or not knowing which indicators to use in combination with each other, can cause sensory overload, confusion and false signals.

In this article I will show you how I use only one indicator but combined with other trading techniques to derive a powerful trading strategy. The indicator we will be looking at is called the Moving Average Convergence/Divergence or MACD for short.

The MACD Indicator

This indicator consists of 3 main parts:

1. The standard MACD (black Line) is calculated using the closing prices of a 12-day exponential moving average (EMA) minus a 26-day EMA.
2. The red signal line is a 9-day EMA plotted next to the MACD line and it signals turns in the indicator.
3. The third part is called the MACD-Histogram which shows the difference between the black MACD line and the red signal line and is plotted in blue either above or below a zero line.

Look at what happens when the MACD line and red signal line cross each other. When the MACD is above the signal line the MACD-Histogram plots above the zero line and vice versa when the lines cross each other the other way around. You can trade this with any type of market, even gold markets.

This short explanation of the parts that make up this indicator might be confusing but all you need to know in this article is that I only look at the blue MACD-Histogram to show me one thing only: a change in a price’s momentum.

Momentum Divergence

Momentum of price movement can be defined as the force at which price is moving in any particular direction. The start of trends normally display an increase in momentum but as a trend matures or come to an end the momentum at which price was moving tend to dry up before a change in direction occurs.

The chart above shows a downward trending market and by using our MACD-Histogram we can see that as price accelerated downwards so did the blue histograms become larger and larger (below the zero line). Soon after the middle mark on the chart price kept moving downwards but the blue histograms showed a decrease in momentum as they became shorter and shorter (closer to the zero line).

This phenomena shows that momentum displayed by the MACD-Histogram started to dry up as price continued its way downwards. This is known as price and momentum divergence i.e. price and momentum is moving in opposite directions.

There is one big problem with momentum divergence indicators though, and that is that they can show divergence from price for a long period of time in a strong trending market, rendering this indicator almost useless when trying to determine the ends of very strong trends.

The MACD-Histogram should therefore not be used on its one but in combination with other tools to make better trading decisions. When used together with other powerful analytical techniques the MACD-Histogram becomes a great tool I would never trade without.

Using the MACD-Histogram as Part of a Strategy

My trading methodology aims to find the end of corrections within a trend so that I only enter trades that trade with the main trend and not against it. To do this effectively I developed my own strategy that follows a systematic process in order to achieve my goal.

My strategy process include:

1. Determining trend and market structure on a larger time frame.
2. Finding areas where corrections are most likely to occur.
3. Switching to a lower time frame once a correction occurs and identifying the type of correction.
4. Using market geometry and Fibonacci ratios to define the characteristics of the correction.
5. Determine where the correction is most likely to end.
6. Switching to an entry time frame once price reaches the area I identified the correction could end at.
7. Wait for a set of entry conditions to appear before I take a trade.

Next we will look at a quick example of a trade setup I identified ahead of time following the processes above. My MACD-Histogram forms part of my entry conditions and is one of the last things I look at before entering a trade during process 7.

Processes 1 and 2

The chart above is that of AUD/USD on a 4 hour time frame. This is my highest time frame I look at and I use it during process 1 to determine trend or change of trend.

It clearly shows how price changed trend early December 2018 when price broke through the blue trend line and previous market structure (red line).

Process 2 requires that I find areas where price (within a trend) is most likely to give me some sort of correction. Using a Fibonacci extension tool on previous price swings I knew that one of the Fib extension levels would act as temporary resistance and offer me a correction of some sort.

Processes 3, 4 and 5

The next 3 processes involves looking at price action and market structure a bit closer to determine which correction type I am dealing with, after which I use additional techniques such as market geometry and Fib ratios to decipher the corrections characteristics.

The serious study of different corrections has helped me identify this corrections as a Symmetrical Triangle correction. Knowing which identifiable characteristics this type of correction displays has helped me to determine, ahead of time, where the correction is most likely to end.

Processes 6 and 7

My last two processes are extremely important and this is where the MACD-Histogram becomes so useful. Price entered the zone I was looking at for this correction to end, two times. The first time was on increased momentum (red line on histogram) which signaled no momentum divergence. Momentum divergence is one of four entry conditions I look at before entering a trade and I have to see momentum divert otherwise the whole trade is off the table.

The second time price entered into my price zone was on momentum divergence (green line) and after I spotted another entry condition in the form of a reversal bar (red oval), I knew that it was time to place an order.

Outcome

The outcome of a very systematical procedure resulted in a trade that had a much higher profit ratio than the original risk. This allowed me to pinpoint the end of a correction ahead of time which allowed me more than enough time to prepare for the trade and nail the absolute low of the correction as well.

Using a smaller time frame like I did during the last procedures together with my MACD-Histogram made it possible to reduce my risk and stack the possibilities of being right heavily in my favor.

Conclusion

What I have showed you in this article is but a brief sample of how I find similar setups that result in high probability trades with very little risk. My entry conditions and the use of my MACD-Histogram make up an important part of my overall strategy that very often keeps me out of losing trades.

Stacking the odds of being successful in the world of trading, in your favor, requires a strategy that relies on a systematic approach where each part has its own important job to do. This allows a trader to break down price action into small manageable parts to find entries with very low risk and large profit potential.