Moving average convergence divergence(MACD)is one of the more popular trading indicators among chart watchers but it's rarely sufficient as a standalone tool. MACD is best used with other indicators and forms of technical analysis. Support and resistance areas and candlestick chart patterns, along with the moving average convergence divergence indicator, can help identify potential market reversals.
Key Takeaways
- Moving average convergence divergence (MACD) is a charting indicator that can be used with other forms of technical analysis to spot potential reversals.
- Support and resistance areas are commonly used with MACD to find price points where the trend might change direction.
- Candlestick chart patterns such as the doji can be used with moving average convergence divergence to see areas on the chart that are deemed technically significant.
- Traders use the MACD as an indication of a trend reversal.
Understanding MACD
Moving average convergence divergence (MACD) is commonly used by traders and analysts as a momentum indicator. The indicator consists of two exponential moving averages (EMAs): a short-term EMA of 12 and a longer-term EMA of 26. It representsthe difference between the two averages as a histogramat the bottom of a chart. MACD overlays the histogram with a nine-day EMA line.
Traders often use the MACD as a divergence indicator to provide an early indication of a trend reversal.
When the price makes a new high or low but the MACD histogram fails to reach a new high or low, the divergence is interpreted as an indication that the current trend's momentum is beginning to wane. The market may soon change direction.
Support and Resistance
Support and resistance areas can sometimes help in identifying times when a market may reverse course. These commonly occur at market turning points. The situational fact lends further likelihood to the MACD's indication that price may soon change direction if the MACD gives a divergence from price indication at an area identified as a major support or resistance level in a market.
Candlestick Charts
The candlestick was invented by Japanese rice merchants in the 18th century. It's a type of price chart that displays the high, low, open, and closing prices of a security. Each bar or candlestick represents one period of trading, such as minutes, days, weeks, or months. It appears as a rectangle (the body) with small lines at the top or bottom (the wicks).
A myriad of trading strategies or signals are generated with candlestick charts, with some patterns on a candlestick chart, notifying traders that a reversal might be at hand. The pattern called the evening star is a bearish reversal pattern at the end of an uptrend. The morning star is a bullish reversal pattern that occurs after a downtrend.
Other candlestick patterns that signal market reversals include the doji, hanging man, orbullish or bearish engulfing candle. A trader recognizing one of these candlestick patterns at the same time that the MACD shows a divergence from the market's price movement has some corroboration of indicators showing the market may be turning and changing trends.
Traders might also pair the MACD moving averages with stochastic closing price data to indicate places where the two indicators cross, forming a double-cross pattern.
What Is the Doji?
The doji is a component of the candlestick chart that's heavily used in trading. The term effectively means "oops" in Japanese. It indicates a mistake and an imminent reversal in a market. It looks like a plus sign or a cross when it appears on a chart.
What Does a Momentum Indicator Do?
A momentum indicator tracks changes in security prices. It predicts the timeframe in which a price is likely to change but it can't tell you if the price will move up or down. It calculates speed rather than direction. It's commonly used in tandem with other indicators to achieve a bigger, clearer picture.
What Are the Best MACD Settings?
Your best choice of settings depends heavily on current market conditions and your trading style and goals. The standard is 12, 26, and 9 but you can vary this based on whether you're investing for the long term or short term. The 12 setting is "fast" and the 26 signal is "slow." Each represents a number of EMA terms.
The Bottom Line
The MACD charting indicator is best used hand-in-hand with other types of analysis. Candlestick chart patterns are commonly used to pinpoint technically significant areas and trend reversals. You might want to begin using it with smaller trades and investments until you're sure you've mastered the art or consider consulting with someone familiar with indicators.
