MACD stands for Moving Average Convergence Divergence and constitutes one of the most famous and powerful trend and momentum technical indicators. Identifying the direction and strength of the trend in the market is critical, in order to be profitable in trading. MACD is the right tool to accomplish this task. As far as day trading is concerned, it is used to identify short term trends and momentum.
Most of the times the price action is following the trend and this is why you have more possibilities to be profitable, while you are trading in accordance with the main trend. Many day trading strategies are based on MACD indicator. However realizing the capabilities and limitations of this tool is of utmost importance.
The MACD settings and components
The default setting of this indicator is: 12, 26 and 9. The three numbers represent a 12 period moving average (MA) of the price, a 26 moving average (MA) of the price and the 9 last periods (or bars in the chart) for which all the estimations are made. The two moving averages of the price are not plotted on MACD diagram.
The first component of this indicator that is plotted on the MACD diagram is the fast moving average that is based on the difference between the 12 and the 26 moving averages of the price. It is this difference that is expressed by the fast moving average. This is also known as the MACD LINE.
The second component that is plotted on the MACD diagram is the slow moving average that is just the average of the fast moving average, for the last 9 time periods. Thus it gives more smooth and accurate estimations. This is also known as the SIGNAL LINE.
The third component that is plotted on the MACD diagram is the histogram, which depicts the difference between the fast and the slow moving averages. The histogram become bigger, as the slow and fast moving averages go away from each other and vice versa. If the distance between the two MAs become bigger we have divergence and if this distance get diminished we have convergence.
Of course the default MACD settings (12, 26, 9) can be customized in order to adapt on a specific day trading strategy. Most of the time the default settings are just right and customization is a matter of experimentation. Different circumstances in the market or different trading style may also suggest different MACD settings. However the default values are used in the most cases.
How to use MACD in Day Trading
There are many ways to use the MACD indicator as an effective trend indicator in day trading and preferably as part of a strategy. In case the fast moving average (MACD line) is crossing the slow moving average (signal line), a new trend possibly is on its way to develop. At this point the height of the histogram is very small and at the crossing time it becomes zero. This is the main signal that is provided by the MACD, suggesting a new trend or pointing out a possible reverse or termination of the prevalent trend.
The direction of the trend is upward when the fast moving average (MACD line) is crossing the slow moving average (signal line) from down to up. So when the MACD line is above signal line the market is bullish and a buy trade is recommended.
The direction of the trend is downward in case that the fast moving average (MACD line) is crossing the slow moving average (signal line) from up to down. So when the MACD line is going below the signal line, the market is bearish and a sell trade is recommended.
Again, at the crossing time of two MAs the value of the histogram becomes zero. This can be a signal to enter a new trade in the respective direction. In accordance to this logic, this can signal a trend reverse and therefore it is time to exit an open trade.
Another signal for a bullish or bearish market is based on whether the MACD histogram is above or below the zero line. The zero line can be considered a support or resistance line. When the MACD histogram is moving above the zero line, then the market is considered bullish, the trend is upward and it is suggested a buy trade. In case the MACD histogram is moving below the zero line, then the market is bearish, the trend is downward and it is recommended a sell trade.
It is highly recommended to confirm a MACD buy or sell signal with at least another indicator. For example a 200 period moving average can be used for confirmation. Traders are used to initiate a buy trade (go long) when the price is above the 200 MA and the slope of the MA is upwards. Traders prefer to go into a sell trade (go short) when the price is below the 200 MA and the slope of the MA is downwards.
Other technical indicators can be used for additional confirmation of a new trade as well. A common complementary indicator for the MACD is an oscillator like the Stochastics technical indicator, which is very effective in order to identify overbought and oversold markets. This additional information signals a possible continuation or reverse of the trend.
How to trade MACD Divergence
The Moving Average Convergence Divergence can also be used in a reversal strategy. In day trading a reversal strategy is more difficult to be applied and more experience is needed. This is where the MACD can give an early signal of an upcoming reverse of the main trend.
At the same time that the price is making lower highs and lows, it is possible the MACD to make higher highs and lows. In this case it is probable the downtrend to reverse and an uptrend to start in accordance with the MACD direction. The signal to initiate a new buy trade, is when a crossover happens and the MACD line is going above the signal line. At the time that the price action of the current market is diverging from the MACD, the prevailed trend is over and the momentum is shifted.
The pitfall of MACD Indicator
The major downside of MACD is that this is a lagging indicator. This is a natural side effect as long as this tool expresses moving averages that are calculated based on the average of moving averages. The consequence in day trading is that sometimes the indicator reacts too late and is not so effective to spot in time smaller trends. Thus it performs better in trending markets.
The Moving Average Convergence Divergence (MACD) indicator is a very effective tool to identify the prevailing trend and momentum in the market. For this reason it is widely used in day trading strategies in order to spot short term trends and momentum shifts in time. Especially the MACD histogram can signal high probability trades, if it is used appropriately.
As it goes for every technical indicator, it is highly recommended to be used combined with one or more other indicators in a strategy, in order to get more accurate results. In day trading an extra confirmation for a trade signal is necessary. Trend following trading strategies are very successful, as long as attention is paid to certain market circumstances. MACD is the underlying indicator for many of these strategies.