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Deep Inside MACD

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Deep Inside MACD
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MACD (Moving Average Convergence Divergence) is considered a powerful signal for both trend followers and momentum chasers.

And it is for a good reason.

To know what makes MACD such a potent indicator, you need to understand each of its components and how each works. In fact, before using any indicator, you must understand its working completely.

So, let’s begin:

COMPONENTS OF MACD

components of MACD

1. The MACD Line

12 Period EMA (minus) 26 Period EMA (Exponential Moving Average)

What this calculation does is to deduct a longer EMA (26 Period) from a shorter (12 Period) EMA.

Let us understand the MACD line with the help of these examples:

12 Period EMA26 Period EMADifferenceNotes
5030+20The trend has become VERY STRONG in the last 12 days
3050-20The trend has become VERY WEAK in the last 12 days
3328+5The trend has become A LITTLE STRONG in the last 12 days
2833-5The trend has become A LITTLE WEAK in the last 12 days

By now, you would have understood that the MACD line represents the CURRENT TREND.

At this point you should know that Gerald Appel, the inventor of the MACD, suggested using the 12-26 MACD line for buying and a 19-39 MACD line for selling IN NEUTRAL MARKETS. He also recommends using a 6-19 MACD combo when markets are SUPER BULLISH and a 12-26 MACD combo when markets are SUPER BEARISH.

2. The SIGNAL Line

The Signal Line is a 9 Period EMA of the MACD line (as above).

The Signal Line therefore can be considered as a smoothed average of the MACD line.

3. The HISTOGRAM

The Histogram is represented by vertical lines and it represents the difference between the MACD Line and the Signal Line.

Before understanding the interpretation, let’s first understand the 3 elements above better with this chart:

MACD and Signal Line

In this example, the 26 EMA is 179.78 and the 12 EMA is 178.36.

So the MACD line is 178.36 (less) 179.78 = -1.42 (as you can see in the chart)

Now the 9 EMA of the MACD line is -0.7396

The Histogram is the difference between these two – that is, -1.42 (-) -0.7396 = -0.68

What do these numbers tell us?

They tell us that:

1. The 12 EMA of TaMO is lesser than the 26 EMA and therefore the current trend is negative. This is the MACD line.

2. The 9 EMA of the MACD line is greater than the MACD. This means that the current trend is bearish because the MACD line has fallen lower than its 9 EMA.

The Histogram Line represents the difference between the MACD and the Signal Line.

4. The ZERO LINE

The Zero line is like a wall that separates the negative and the positive values of the MACD and Signal Lines. When these lines are positive, they will be above the Zero Line, and vice versa.

Now, let us learn how to interpret the MACD:

HOW TO INTERPRET MACD

1. MACD LINE CROSSES ABOVE THE SIGNAL LINE AND BOTH ARE ABOVE THE ZERO LINE

When both the MACD and Signal Lines are above the Zero Line, it obviously indicates that the trend is bullish. Now in a bullish trend, when the MACD Line crosses above the Signal Line, it implies that the bullish trend is gathering momentum.

2. MACD LINE CROSSES ABOVE THE SIGNAL LINE AND BOTH ARE BELOW THE ZERO LINE

When both the MACD and Signal Lines are below the Zero Line, it obviously indicates that the trend is downward. Now in a bearish trend, when the MACD Line crosses above the Signal Line, it implies that the trend has turned bullish.

3. MACD LINE CROSSES BELOW THE SIGNAL LINE AND BOTH ARE ABOVE THE ZERO LINE

When both the MACD and Signal Lines are above the Zero Line, it obviously indicates that the trend is bullish. Now in a bullish trend, when the MACD Line crosses below the Signal Line, it implies that the trend has turned bearish.

4. MACD LINE CROSSES BELOW THE SIGNAL LINE AND BOTH ARE BELOW THE ZERO LINE

When both the MACD and Signal Lines are below the Zero Line, it obviously indicates that the trend is bearish. Now in a bullish trend, when the MACD Line crosses below the Signal Line, it implies that the bearish trend is gathering momentum.

5. INTERPRETING THE HISTOGRAM

The Histogram represents the difference between the MACD Line and the Signal Line. When the line is long or keeps getting longer it implies that the momentum is getting stronger. Know know that momentum becomes very strong, it gives way to profit booking and therefore, a few long Histogram lines followed by a shorter line signals that the momentum and volatility may be coming to an end.

Likewise, when the line becomes very short it implies that volatility may have ended, and that the trend is about to change.

6. INTERPRETING THE CONVERGENCES AND DIVERGENCES & ZERO LINE CROSSOVERS

There are tons of videos and posts online that go ga-ga about the divergences, convergences and the zero line crossovers.

However, per my experience, if you know Volume Spread Analysis, you will get signals much ahead of MACD’s convergences and divergences.

Any indicator that you use, you must know it thoroughly inside out. Unless you know how an indicator works, don’t use it because someone says so.

Hope this post helped you learn MACD inside out.

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