Stock trading involves in-depth analysis. You need to have all the necessary details of the stock you are investing in to ensure that you can book profits on your investments. From reading financial statements to technical charts and indicators to predicting the momentum of stocks – it takes a lot of research and facts to get your investment right. Technical indicators have become especially popular in the trading community since you can get elegant computerised charts that can help you understand the momentum and trends of stocks. Let’s understand what is a MACD indicator and how to use it.
What is the MACD Indicator?
Short for Moving Average and Convergence Divergence, MACD is a popular momentum and trend-following indicator that was developed in by Gerald Appel. The indicator is centred on the information of moving averages, making it a credible momentum filter and tool, which you can use while trading in the stock market. The indicator is designed in such a way that analysts can reveal changes in momentum, strength, trends and direction while analysing stock processes. Primarily, this indicator consists of three main, individual components that you should know about before you can understand how to use MACD effectively. They are as under:
1. The MACD Line
The MACD line is regarded as the heart of the MACD indicator. While speaking of MACD, the term exponential moving averages or EMA is often used. The MACD line is by default, the difference between the 12 and 26 period EMA, which makes it a complete moving average crossover system.
2. The signal line
The signal line is the second, crucially important component of the MACD indicator. It indicates the 9-period EMA (default setting) of the MACD Line.
3. The MACD histogram
The third component, after the two moving lines, is the histogram, which represents the difference between the MACD and Signal lines. It is represented as MACD Histogram: MACD Line – Signal Line.
How to use the MACD indicator?
As mentioned above, the MACD is mainly a trend and momentum indicator. As a trader, you can use the various signals given by this indicator to predict the trends, momentum, and changes of the stock prices. The MACD indicator generates different signals which you can use to predict the changes while learning how to read MACD charts. They are as under:
1. The MACD Hook
The MACD hook occurs or materialises when the signal line tries penetrating or succeeds in penetrating the MACD line, turning at the last movements. This means that the hook happens when the signal and MACD lines touch each other, without crossing. The MACD hook primarily identifies the moves that are going against the trend, i.e. counter-trend within trending markets. The hook can become helpful for trading to purchase pullback during an uptrend and sell them during a downtrend. It also assists traders in identifying potential trade setups, making it quite a useful tool. As a trader, if you wish to enter a position, you should wait for the hook to materialise and confirm that the trend has indeed changed.
2. The hidden divergence
The hidden divergence is the second thing you should know about how to use MACD. When the stock price moves in one direction (whether it is up or down), while the indicator moves in another direction simultaneously; it can be said that divergence has occurred. In simple words, hidden divergence is the exact opposite of divergence and is referred to in the context of bullish and bearish divergence formations. The bullish divergence is formed when the current low of the rate or price exceeds the previous swing low, causing the MACD line to create an opposite pattern. The Bearish divergence, on the other hand, is the stark opposite of the bullish divergence. It occurs when the rate or price starts moving in the down-trend and makes higher highs as well as lower high patterns, with the MACD making an opposite pattern.
3. The histogram squeeze
The final thing you should know about how to use MACD is the histogram squeeze. When the price range of the stock starts getting tight and small at a time when the market volatility is low; the chances of explosive breakouts can increase manifolds. As a trader, you can spot the MACD Histogram and identify that the explosive breakout trends are imminent, and may occur anytime soon. However, to find out about an impending breaking, you should first check and ensure that the price comes into a small range. Also, remember that at this point, you should know how to read MACD histogram, which should look flat. You can begin the trade at the time when the price of the stock breaks the small range, while the histogram expands at the same time.
How to read MACD indicator – Points to remember
Here’s a break-down on how to read MACD indicator effectively
1. The main signals the MACD indicator generates are crossovers with the signal line.
2. In case of crossovers with the signal line, the MACD line rises faster than the signal line, crossing it from below.
3. Such a signal is construed as bullish, suggesting an acceleration of the price growth.
4. If the MACD line falls faster than the signal line, crossing it from above, the signal is construed as bearish, suggesting an extension of price losses.
5. If the MACD line and the price are trending in the same direction, the pattern formed is known as convergence, and it confirms the movement in price.
6. If the movement occurs in the opposite direction, the pattern formed is known as divergence.
Now that you know how to use MACD effectively and read it, you can use it to your advantage while stock trading. Remember, there is no particular best time to use the MACD indicator, and it entirely depends on your personal preferences and trading plans. Reach out to Angel One for more details on MACD indicators.