What is MACD? A MACD trading strategy example

An explanation of what the MACD trading indicator is and a guide to using the MACD as part of a day trading strategy.

Summary

  • What is MACD?
  • How to read the MACD indicator
  • Drawbacks of using MACD
  • Using MACD in a trading strategy

What is MACD?

The MACD indicator is a popular price indicator used for day trading and forex trading. It measures the difference between two exponential moving averages and plots the difference as a line chart. The difference between the MACD line and a second signal line is then plotted as an easy-to-interpret histogram.

 

MACD flow2-1

Like all technical indicators, the settings of the MACD can be changed to different time periods but traders tend to prefer the defaults. The defaults are 12 and 26-periods for the EMAs, with the signal line as a 9-period EMA of the MACD line.

How to read the MACD indicator

There are two important ways to read the MACD indicator.

  1. Whether market is overbought or oversold
  2. Whether the market is up-trending or down-trending

Overbought / oversold

This is a screenshot of the MACD indicator the way it is setup in the FlowOne trading platform. You can see that peaks in the MACD indicator match peaks in the price and toughs in the indicator match troughs in the price.

 

MACD flow2

 

This is because the MACD tends to oscillate between positions of being overbought when it will form a peak to positions of oversold when it forms a low.

This is useful information for traders because the MACD indicator can show them when the price might be about to form a high or low. Traders would want to reduce long positions near the peaks and add to short positions, while reducing short positions near the lows and add to long positions.

Uptrend or downtrend

The MACD is not constrained between -1 and +1 like some technical indicators but it does have a zero line through the middle. When the MACD is above zero, the trader can interpret the price as moving higher in an uptrend. While the MACD is below zero, the trader can consider the price as falling within a downtrend.

 

MACD flow3

 

A trader can use this information as part of a trading strategy to determine the direction of the market. Traders using a trend following system would only buy when there is a MACD is above the zero line while traders using a mean reversion system would only sell. Likewise trend followers would want to sell while the MACD is below zero and countertrend traders would be looking for trading opportunities to buy.

Drawbacks of using MACD

Each of the two ways of interpreting the MACD have their disadvantages.

  1. By the time the MACD crosses above the zero line, the price is normally well above the bottom. Equally when the MACD crosses below the zero line, the top has normally already happened. Using the zero level of MACD is a lagging indicator for the price - meaning you get the indicator signal after the price has changed direction.
  2. When the MACD reaches an overbought level, the price can remain in an uptrend for a significant period afterwards. Similarly, when the MACD reaches an oversold level, the downtrend can continue for a longer period afterwards.

There are ways to mitigate these downfalls of the MACD such as waiting for the MACD to go overbought or oversold for a second time - forming its own double top. Or by only trading in the direction of a longer term trend, as done in the following example strategy.

An example MACD trading strategy

The rules of any day trading system must be clearly defined and easy to follow. This systems is known as the MACD crossover. The rules to this example trading system are as follows:

LONG/SHORT: Take long MACD signals when price is above the 200 period-moving average

ENTRY: Buy when the MACD crosses over the zero line

EXIT: Sell at a profit or loss when the MACD crosses below the zero line

Here you can see an example of the strategy at work:

 

MACD flow4

 

How this system works is that it aims to buy when the MACD confirms the price is moving from a down-trending environment to an up-trending environment. It then aims to ride this uptrend as long as possible before selling when the MACD signals the price is moving back into a downtrend. There is also the additional criteria that the price should be above the 200-period moving average to avoid taking trades against the direction of the major trend.

This is the outlines of a trading strategy that does not include important elements like which markets and timeframes to trade and risk management rules such as cutting losses over a certain size etc. The strategy can apply to any market, timeframe, or risk management strategy so long as the rules are consistently followed.

 

I hope this was useful, please make sure to read our next guide:

Trading Strategy: Breakouts or pullbacks?

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