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Trading 101: How to Trade using Momentum

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Trading 101: How to Trade using Momentum

Introduction

This article was posted on Tuesday, 16:34, UTC.

Momentum is an interesting concept.  When you relate it to people and those who trade the markets, momentum reflects the change in sentiment and the inertia of the price movements. When things are going well, the good times are rolling and when bad things start to appear, the sky can be falling.  People use the saying, “when it rains it pours” which means that when negative momentum accelerates, things can turn awful quickly.

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Since human emotion is an important part of determining future price movements, measuring momentum is a tool that should be part of your trading arsenal. There are a number of good indicators that you can use to measure momentum and one of the best is the Moving Average Convergence Divergence Index (MACD).

The Development of the MACD Indicator

The MACD was developed by Gerald Appel in the late 1970’s. The initial MACD only included a portion of the index and histogram that is used by investors today.  Gerald’s goal was to determine momentum by evaluating the difference in two different moving averages.  By analyzing the difference in specific moving averages, you can visually see that when the difference is expanding, momentum is accelerating and when the difference is contracting momentum is decelerating.

What Does the MACD Calculate?

The formula that is used to calculate the MACD subtracts the 26-day exponential moving average from the 12-day exponential moving average, which is called the MACD index.  An exponential moving average differs from a standard moving average as it puts more weight on current prices and less weight on differed prices.

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The second piece of the MACD is the signal line.  This is calculated by generating a 9-day exponential moving average of the MACD index

During the last 4-decades, analysts and traders have altered the index and signal line to fit their needs.  For example, if you wanted to capture short term momentum, you could change the index to the difference between the 5-day exponential moving average and the 13-day exponential moving average, and alter the signal line to be the 12-day moving average of the index.

Using the MACD

The chart above shows an MACD index as well as signal line, which is in the section below the price of WTI crude oil. Additionally, it shows the MACD histogram which was created nearly a decade after Appel initially introduced the MACD index by Thomas Aspray.  The MACD histogram measures the distance between the MACD Index and the MACD signal line and displays this number on a histogram.  The benefit of seeing this difference on a chart is that you can tell when the histogram is beginning to shift its trajectory.

There are a few ways that you can use the MACD to enhance your trading by evaluating momentum.  The most common way to use the MACD is finding crossover signals.  When the MACD index crosses above the MACD signal line, a buy momentum signal is generated. When the MACD index crosses below the MACD signal line, a sell momentum signal is generated.

In the chart of crude oil, the green arrow shows you an MACD crossover buy signal. It tells you when positive momentum is accelerating and prices are likely to continue to move higher. The red arrow in the chart describes a spot where negative momentum is accelerating and prices are likely to continue to move lower.

Since the histogram is the difference between the signal line and the index, the MACD histogram should move from negative to positive territory when a buy signal is generated (which occurred at the green arrow), and the MACD histogram should move from positive to negative territory when a sell signal is generated (which occurred at the red arrow).

One of the benefits of using the histogram is you can analyze the trajectory of momentum. Prior to the buy and sell signal, the MACD histogram started to show that momentum was accelerating.  In the case of the buy signal, positive momentum was beginning to accelerate and in the case of the sell signal, negative momentum started to accelerate.

Since there are no hard and fast rules on how you should use the MACD histogram in conjunction with the crossover signals, many use the histogram to anticipate a crossover, by analyzing its trajectory.

MACD Divergences

Another way you can measure momentum with the MACD is to determine divergences.  The term describes a scenario where prices and momentum are moving in the opposite direction.  An example can be seen in the same crude oil chart.

In the example above, the price crude oil is moving lower in May shown near the red arrow.  As prices continue to decline below the March lows, momentum begins to decelerate and does not hit a new lower low in tandem with prices.  You can see that the trend of the MACD histogram is moving upward (green arrow). When prices are moving lower, and momentum begins to decelerate, you have a situation where divergence is occurring.  This usually signifies that an asset price is ready to reverse course.

Summary

  • The Moving average convergence divergence (MACD) is a momentum index that is used to determine changes in momentum. The MACD index was introduced in the 1970’s and is calculated by subtracting the 26-day exponential moving average from the 12-day exponential moving average.
  • The MACD signal line is the 9-day exponential moving average of the MACD index.
  • Gerald Appel used exponential moving averages in the MACD calculation to weight current prices more than differed prices when determining current momentum.
  • One of the most popular ways to use the MACD is to evaluate crossover buy and crossover sell signals. When the MACD index crosses above the MACD signal line a buy signal is generated. When the MACD index crosses below the MACD signal line as sell signal is created.
  • In 1986 the MACD histogram was introduced by Thomas Aspray. The histogram reflects the difference between the MACD Index and the MACD signal line and displays this difference in a histogram format.
  • The histogram can be very helpful in confirming and anticipating an MACD crossover buy or sell signal.
  • The MACD crossover buy and sell signals are the most common way the MACD is used. An alternative method of judging momentum is to use the MACD to evaluate divergences. When prices are moving in the opposite direction of momentum, and momentum is decelerating, a reversal in price action is imminent.
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David Becker

David Becker

David Becker is a New York-based finance writer and capital markets analysis. With more than 25 years of experience in derivatives trading and risk analysis, David runs a consulting business that focuses on investment evaluation and personal finance. David has been published on high profile online and print media. He holds a B.A. in economics.

Comments
  • user

    AUTHOR tuth

    Posted on 5:06 pm June 27, 2017.

    which indicator works fine with macd? i think psar is a good partner for it. what do you think? and how much do you wait for confirmation? 2 candle is ok?

  • user

    AUTHOR embersburnbrightly

    Posted on 9:26 pm June 27, 2017.

    Great article, very helpful to me, as someone still learning the ropes. Thank you!

  • View Comments (2) ...
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