MACD
MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After all, our #1 priority in trading is being able to find a trend, because that is where the most money is made.
With MACD charts, you will usually see three numbers that are used for its settings. The first is the number of periods that is used to calculate the faster moving average, the second is the number of periods that is used in the slower moving average, and the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
For example, if you were to see “12,26,9” as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:
1. The 12 represents the previous 12 bars of the faster moving average.
2. The 26 represents the previous 26 bars of the slower moving average.
3. The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (The blue lines in the chart above).
There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the difference between the 12 and 26 period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9 period moving average. This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our “slower” moving average. What this does is it smoothes out the original line even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that as the two moving averages separate, the histogram gets bigger. This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average. As the moving averages get closer to each other the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average. And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, I need to crack my knuckles after that one.
Ok, so now you know what MACD does. Now I’ll show you what MACD can do for YOU.
MACD Crossover
Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one. When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, which often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears. This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.
There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it's just an average of historical prices. Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, it is still one of the most favoured tools by many traders. Let's now take a look at Parabolic SAR...
Parabolic SAR
Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends. And although it is important to be able to identify new trends, it is equally important to be able to identify where a trend ends. After all, what good is a well-timed entry without a well-timed exit?
One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop and Reversal). A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement. From the chart above, you can see that the dots shift from being below the candles during the uptrend, to above the candles when the trend reverses into a downtrend.
Using Parabolic SAR
The nice thing about the Parabolic SAR is that it is really simple to use. Basically, when the dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal. This is probably the easiest indicator to interpret because it assumes that the price is either going up or down. With that said, this tool is best used in markets that are trending, and that have long rallies and downturns. You DON’T want to use this tool in a choppy market where the price movement is sideways.
Stochastic
Stochastic is another indicator that helps us determine where a trend might be ending. By definition, stochastic is an oscillator that measures overbought and oversold conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.
How to Apply Stochastics
Like I said earlier, stochastics tells us when the market is overbought or oversold. Stochastics are scaled from 0 to 100. When the stochastic lines are above 70 (the red dotted line in the chart above), then it means the market is overbought. When the stochastic lines are below 30 (the blue dotted line), then it means that the market is oversold. As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.
Looking at the chart above, you can see that the stochastics has been showing overbought conditions for quite some time. Based upon this information, can you guess where the price might go?
If you said the price would drop, then you are absolutely correct! Because the market was overbought for such a long period of time, a reversal was bound to happen.
That is the basics of stochastic. Many traders use stochastic in different ways, but the main purpose of the indicator is to show us where the market is overbought and oversold. Over time, you will learn to use stochastic to fit your own personal trading style. Okay, let's move on to RSI.
Relative Strength Index (RSI)
Relative Strength Index, or RSI, is similar to stochastic in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 20 indicate oversold, while readings over 80 indicate overbought.
Using RSI
RSI can be used just like stochastic. From the chart above you can see that when RSI dropped below 20, it correctly identified an oversold market. After the drop, the price quickly shot back up.
RSI is a very popular tool because it can also be used to confirm trend formations. If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50. If you are looking at a possible uptrend, then make sure the RSI is above 50. If you are looking at a possible downtrend, then make sure the RSI is below 50
In the beginning of the chart above, we can see that a possible uptrend was forming. To avoid fake outs , we can wait for RSI to cross above 50 to confirm our trend. Sure enough, as RSI passes above 50, it is a good confirmation that an uptrend has actually formed. Okay, we've covered a smorgasbord of indicators, let's see how we can put all of what you just learned together (its combination).
Putting It All Together
In a perfect world, we could take just one of these indicators and trade strictly by what that indicator told us. The problem is that we DON’T live in a perfect world, and each of these indicators has imperfections. That is why many traders combine different indicators together so that they can “screen” each other. They might have 3 different indicators and they won’t trade unless all 3 indicators give them the same answer.
As you continue you journey as a trader, you will discover what indicators work best for you. I can tell you that I like using MACD, Stochastics, and RSI, but you might have a different preference. Every trader out there has tried to find the “magic combination” of indicators that will always give them the right signals, but the truth is that there is no such thing.
I urge you to study each indicator on it’s own until you know EXACTLY how it reacts to price movement, and then come up with your own combination that fits your trading style. Later on in the course, I will show you a system that combines different indicators to give you an idea of how they can compliment each other.
Summary:
- Everything you learn about trading is like a tool that is being added to your trader’s toolbox. Your tools will make it easier for you to “build” your trading account.
- Bollinger Bands
- Used to measure the market’s volatility
- They act like mini support and resistance levels
- Bollinger Bounce
- A strategy that relies on the notion that price tends to always return to the middle of the Bollinger Bands
- You buy when the price hits the lower Bollinger band
- You sell when the price hits the upper Bollinger band
- Best used in ranging markets
- Bollinger Squeeze
- A strategy that is used to catch breakouts early
- When the Bollinger bands “squeeze” the price, it means that the market is very quiet, and a breakout is eminent. Once a breakout occurs, we enter a trade on whatever side the price made its breakout.
- MACD
- Used to catch trends early and can also help us spot trend reversals
- It consists of 2 moving averages (1 fast, 1 slow) and vertical lines called a histogram, which measures the distance between the 2 moving averages.
- Contrary to what many people think, the moving average lines are NOT moving averages of the price. They are moving averages of other moving averages.
- MACD’s downfall is its lag because it uses so many moving averages.
- One way to use MACD is to wait for the fast line to “cross over” or “cross under” the slow line and enter the trade accordingly because it signals a new trend.
- Parabolic SAR
- This indicator is made to spot trend reversals; hence the name Parabolic Stop And Reversal (SAR)
- This is the easiest indicator to interpret because it only gives bullish and bearish signals.
- When the dots are above the candles, it is a sell signal.
- When the dots are below the candles, it is a buy signal.
- These are best used in trending markets that consist of long rallies and downturns.
- Stochastics
- Used to indicate overbought and oversold conditions
- When the moving average lines are above 70, it means that the market is overbought and we should look to sell.
- When the moving average lines are below 30, it means that the market is oversold and we should look to buy.
- Relative Strength Index (RSI)
- Similar to stochastics in that it indicates overbought and oversold conditions.
- When RSI is above 80, it means that the market is overbought and we should look to sell.
- When RSI is below 20, it means that the market is oversold and we should look to buy.
- RSI can also be used to confirm trend formations. If you think a trend is forming, wait for RSI to go above or below 50 (depending on if you’re looking at an uptrend or downtrend) before you enter a trade.
- Each indicator has its imperfections. This is why traders combine many different indicators to “screen” each other. As you progress through your trading career, you will learn which indicators you like the best and can combine them in a way that fits your trading style.
I know this has been a very loooooooooooonnnnng lesson, and I encourage you to go back and read over anything you haven’t fully understood yet. Sometimes it just takes a couple times of reading before you truly grasp something. Once you understand the concepts of these indicators, go to a chart and start playing with them. Really study how each indicator reacts to the price movement.
When you fully understand an indicator, then it will become another tool for your trader’s toolbox. For now you should just take a break. Grab some coffee or get something to eat. I know your eyes are hurting! Let this lesson soak in, and then come back when you’re refreshed!
The price of success is hard work, dedication to the job at hand, and the determination that whether we win or lose, we have applied the best of ourselves to the task at hand.
- Vince Lombardi
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