Top Trading Strategies Using MACD Indicator – Must Know For Trading

Top Trading Strategies Using MACD Indicator: Technical tools are an important aspect to consider by market participants to analyse the securities and build strategies for good rewards.

One of the most important technical indicators to use in analyzing securities for good entry and exit opportunities is the MACD indicator.

Here, we shall discuss in detail the meaning, formulation, and top trading strategies using MACD indicator with its advantages and disadvantages.

What is MACD?

MACD stands for moving average convergence divergence which is a momentum-based trend-following indicator.

MACD indicator consists of a MACD line, signal line and histogram which are based on the moving average of securities price.

where,

• The MACD line and the signal line indicate entry and exit opportunities in the price of a security.
• The histogram represented over zero line indicates bullish and bearish momentum present in the security.

Convergence occurs when two moving averages move towards each other and divergence occurs when two moving averages move apart from each other.

As the moving averages diverge and converge, the MACD indicator oscillates generating buy and sell signals in security.

The indicator prefers an exponential moving average(EMA) rather than a simple moving average(SMA) as a base to plot because EMA gives more weightage to the recent closing price of a security.

Formula to calculate MACD indicator

The MACD indicator uses a default value of 26 EMA, 12 EMA and 9 EMA, and it is calculated as explained below.

• MACD line:- short-term EMA – long-term EMA.

                               I.e 12 EMA – 26 EMA.

• Signal line:- Two EMAs are subtracted to create 9 period EMA.

                    I.e  9-period EMA of the MACD line.

• Histogram:- It is a difference between the MACD line and the Signal line that oscillates above and below the zero line.

What does histogram signify?

• The histogram becomes positive when the MACD line is above the signal line.
• The histogram becomes negative when the MACD line is below the signal line.
• The histogram will become zero at the point MACD and signal line crossover.
• The histogram becomes larger or shorter when the MACD line and signal line widen or converge respectively.

Top Trading strategies Using MACD indicator

MACD indicator helps traders develop strategies to find entry and exit opportunities with potential views and well-defined risk-to-reward ratios.

Crossover strategy

The MACD line and the signal line crossover of the indicator signals entry and exit opportunity in a price of security.

When the MACD line crosses above the signal line it indicates a buy signal and one can enter a long position in the security to capture upward movement.

Also, traders can book the profits in a short position when the MACD line crosses below the signal line.

(Chart of nifty 50 showing the formation of cross-over strategy for a long position)

When the MACD line crosses below the signal line of the indicator, it indicates a sell signal and one can enter a short position in the price of a security to capture the downside movement.

Also, traders can book the profits in a long position when the MACD line crosses above the signal line.

(Chart of nifty 50 showing the formation of crossover strategy for a short position)

Zero Crossover strategy

The Zero line of the MACD indicator signals entry and exit opportunities in a price of security.

When the MACD signal line of the indicator crosses above the zero line it indicates an upside movement in the security, and here traders can enter a long position in the security to take benefit of the upside movement.

(Chart of Axis Bank showing the formation of zero cross-over strategy for a long position)

When the MACD signal line of the indicator crosses below the zero line it indicates a downside movement in the security, and here traders can enter a short position in the security to take benefits of the downside market.

(Chart of HDFC Bank showing the formation of zero cross-over strategy with an entry to a short position)

Below is an example of a Reliance Industries chart in which the zero line crossover strategy of the MACD indicator is combined with shorter and longer EMA for confirmed signals.

Divergence

MACD divergence occurs when the price of a security is trading in opposite direction to the change in momentum of a MACD indicator.

Two types of MACD Divergence

1. Bullish Divergence
2. Bearish Divergence 

Bullish Divergence.

A bullish divergence is formed when the price of a security is making a lower low, but the MACD indicator is diverging by higher lows. This shows that bullish momentum in the security can be expected and one can take longs in the market with strict stop loss.

As a confirmation, entry can be placed after the MACD line crosses above the signal line of the indicator.

(Chart of Nifty Bank showing the formation of Bullish Divergence with MACD indicator)

Bearish Divergence.

A bearish divergence is formed when the price of security records a higher high but the MACD indicator forms lower highs. Here the weaker momentum formed in the MACD signals to take a short position or exit the long position. For short positions one can place Strict Stop loss

It is advised to take a confirmed trade once the MACD line crosses below the signal line of the indicator.

Chart of ICICI Bank showing the formation of bearish divergence with MACD indicator.

Advantages of MACD indicator

• The indicator provides valuable buy and sell signals with MACD and signal line crossover.
• The above-discussed MACD indicator strategies help traders build potential views on the market and also spot possible entry and exit opportunities.
• MACD indicator helps identify trends and bullish or bearish momentum present in the security.
• The divergence formed with the MACD indicator helps to spot clear trend reversal opportunities.

Disadvantages of MACD indicator

• It is a lagging indicator.
• It is well preferred for short to medium-term trading opportunities as the longest time period used in the MACD indicator is 26 days.
• The delayed signals can lead to exit early or missing out on entry positions of the security in trending markets.
• The MACD indicator in range-bound markets can generate false signals leading to wrong trades.

In Closing

Technical analysis of the MACD indicator can be considered to enter a trade in securities with well-informed views and strategies.

MACD indicator helps traders analyse the security to build potential entry and exit opportunities in security.

As a part of technical analysis, it is always preferred to use the MACD indicator in conjunction with other technical analysis tools like indicators, candlestick patterns and chart patterns to have a confirmed entry with good risk-reward ratios. 

Written By Deepak M

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