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MACD

The MACD ("Moving Average Convergence/Divergence") can be used in both trends and ranges if used properly. It is a trend following momentum indicator that shows the relationship between two moving averages of prices. This is one of the few tools that will work well in both types of markets. If I could only have one technical indicator outside of trend lines/support/resistance, this would be it. It was developed by Gerald Appel, publisher of Systems and Forecasts.

The MACD "oscillator" or "indicator" is a collection of three signals (or computed data-series), calculated from historical price data, most often the closing price. These three signal lines are: the MACD line, the signal line (or average line), and the difference (or divergence). The term "MACD" may be used to refer to the indicator as a whole, or specifically to the MACD line itself. The first line, called the "MACD line", equals the difference between a "fast" (short period) exponential moving average (EMA), and a "slow" (longer period) EMA. The MACD line is charted over time, along with an EMA of the MACD line, termed the "signal line" or "average line". The difference (or divergence) between the MACD line and the signal line is shown as a bar graph called the "histogram" time series (which should not be confused with the normal usage of histogram as an approximation of a probability distribution in statistics - the commonality is just in the visualization using a bar graph).

A fast EMA responds more quickly than a slow EMA to recent changes in a stock's price. By comparing EMAs of different periods, the MACD line can indicate changes in the trend of a stock. By comparing that difference to an average, an analyst can detect subtle shifts in the stock's trend.



Trading with moving averages

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MACDSince the MACD is based on moving averages, it is inherently a lagging indicator. However, in this regard the MACD does not lag as much as a basic moving average crossing indicator, since the signal cross can be anticipated by noting the convergence far in advance of the actual crossing. As a metric of price trends, the MACD is less useful for stocks that are not trending (trading in a range) or are trading with erratic price action.

There are several ways to use the MACD indicator for trading with moving averages. In up trends, you'll only take buy signals as the price is also somewhat near the uptrend line. All of this will be illustrated in a visual below. However, let's go into how to read the signals more.

When the MACD lines go downward, then cross and turn upward, you have a MACD buy signal. You can get a head jump on the MACD lines crossing many times by using the Histogram bars. When the lines are heading down and the lines look like they are attempting a cross but haven't yet, you can look to the histogram bars for a head jump on the actual signal. When the MACD is wanting to turn upward and the red histogram bars start to get less negative (meaning they are growing shorter), then you can try to buy ahead of the signal (crossing).

When the MACD lines are trying to turn down, you can look to the black lines to start growing shorter to get a quicker entry on the MACD signal lines. This will help you sell in a more timely fashion. Follow the below rules to succeed trading with moving averages:

  1. Bear in mind that MACD is a lagging indicator and your entry or exit point may not be lowest or the highest price for your time frame. Many traders criticize MACD (Moving Average - Convergence Divergence) as an indicator that fails to respond well to ranging market conditions. MACD is prone to whipsaw and it is very possible that beginner traders may suffer substantial losses if they are not careful. To avoid such losses a trader should only trade in the direction of his defined trend and should have automatic stop loss orders with his stock broker.
  2. Define your trend. If your trend is upward, trade only long stock trades, and if your trend is downward, trade short stock trades.
  3. The maximum divergence is proportionate to the volatility of the stock. Study the past history of the stock's maximum divergence to determine reasonable large swings (crests and troughs). Trade only if the divergence has formed a reasonable trough or crest. Values of between -2.5 and 2.5 may only represent a ranging market and you are likely to be whipsawed.
  4. Depending on which stock market index you track, and the time period you track, all of the MACD methods reduce risk (volatility) without significantly reducing overall returns as compared to buy-and-hold. However, there have also been long stretches where timing underperformed buy-and-hold, which can make it a hard strategy to implement over the long run. The main reason we are talking about them now is only due to recent hot performance. In addition, market timing requires regular attention to stock market activity, increased trading costs, and tends to be much less tax-efficient.
  5. Always keep an automatic stop loss order in place.
  6. If your trend changes direction, exit immediately. Do not wait an extra one more day to see if things will come back to what you want - this is where most problems of many traders start.

Share market strategies

The daytrader

  1. Opening range breakout
  2. Market timing
    To buy Satyam after it was rescued from brink of bankruptcy, you had to have huge confidence in your ability to read trends.
  3. Elliott wave trader
  4. Hedging
    1. What is hedging?
    2. How to hedge?
  5. Rules for investing
  6. Moving average
    1. MACD
    2. Stochastic oscillator
      Indicates whether market's moving to new highs, new lows or just moving nowhere.
    3. Bollinger bands
    4. Relative strength index
  7. Swing trading guide
  1. Trading for a living
  2. Short term trading strategies
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  3. Price action trading
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  5. What is a swing trader?
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    For those who do not know about day trading.


What can you do with LinkedIn?

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