MACD and the zero line
MACD and the zero line
There are various popular indicators such as the slow stochastic, the relative strength index (RSI), the commodity channel index (CCI), the Bollinger bands and the moving averages. On one hand, the “CCI” compares the price to a moving average. On the other hand, the “RSI” compares the recent gains to the recent losses. Similarly, the slow “stochastic” compares the closing price to a price’s range over a set period of time. However, apart from these popular instruments, there is another "trading tool". This article allows traders to grasp MACD and the zero line.
What is MACD?
MACD is an acronym for Moving Average Convergence-Divergence. It is an immensely popular indicator developed by Gerald Appel and compares a short term exponential moving average to a long period exponential moving average. Traders use different settings for the instrument, but the standard setting is (12,26,9). It compares the exponential moving average twelve to the exponential moving average twenty six. The difference between these two averages is the “MACD“. The trading instrument also has its own moving average nine and oscillates around the zero line or the waterline. Contrary to other oscillators, this trading tool has neither an upper limit nor a lower boundary. Though the primary role of this “tool” is to confirm the trend, it can also indicate an overbought or an oversold market situation like any other oscillators. No doubts, this is a remarkable oscillator, but its most compelling feature is the zero line.
The zero line
It is commonly known as the waterline and represents the long term moving average or the exponential moving average twenty six for the standard (12,26,9). Similarly, the waterline for the oscillator (25,50,9) is the long term moving average fifty. A positive momentum surge occurs when the oscillator crosses above the waterline. On the other hand, the bearish momentum is increasing when the oscillator goes below the equilibrium line. Though, this trading “tool” is the difference between two moving averages, it is in fact, a replica of the short term moving average with its own exponential moving average nine. There are more to this “indicator“, but these will form the subject of a different article. In theory, the exponential moving average twelve will cross above the twenty six, after the oscillator crosses above the zero line and vice versa. However, the waterline's crossings do take place before the moving average's crossovers. For instance, the oscillator (12,26,9) may cross below the equilibrium line before the moving average twelve crosses below the moving average twenty six. It is clear that though the trading tool is a lagging indicator like moving averages, it can provide leading signals.
The waterline divides the markets into two zones: the bullish area above it and the bearish zone below the equilibrium line. One should apply bullish strategies above the waterline and revert to bearish trading methods once the “indicator” returns below it. It may look fairly straightforward, but the fact of day trading or swing trading is far from the theory. This trading instrument is similar to marmite. Either one hates it or adores it. Many traders gave up on the Moving Average Convergence-Divergence. Some do not understand it, but the frequent trading mistake is to trade the “indicator” instead of trading the financial instrument. The waterline is also a warning line, but it is common to see the oscillator crossing above the zero line and quickly returning below it and vice versa. Traders who always look at the indicator instead of the price usually lose. When the oscillator immediately abandons a bullish signal or a bearish waterline crossover, unaware traders can make wrong decisions. Traders can avoid frequent trading mistakes when using this guide.
Apart from other trading rules, one should understand the equilibrium line crossovers. A rise in bullish momentum takes place when the trading instrument crosses above the zero limits. However, the bullish growth becomes effective when resistances, trend lines, channels break to the upside and the price finds support above them. If there is an optimistic momentum rise but the price fails to exceed the nearest and closest resistance levels, traders should wait. There is no need to be a brave or an aggressive trader. The indicator will return below the equilibrium line if the bullish momentum stalls. In an uptrend, the price will exhibit higher lows and higher highs, until it fails to show a new higher high. On the other hand if a valid bearish momentum eruption occurs, the price will drop below support levels. In this instance, one will expect the price to:
1/ appear below a support level,
2/ to retest the support level
3/ and to turn around.
These three conditions allow reasonable and patient traders to enter the trade at the right time and the perfect place with a minimum risk. If there is no bearish validation, the Moving Average Convergence-Divergence will promptly return above zero. Once a thriving bearish force is dominant, the price should exhibit lower lows and lower highs until it fails to show a new lower low. Note that the emergence of a new trend very often coincides with the waterline's crossovers. However, the beginning of a new trend does not always lead to a full trend with five “Elliott waves“. The price does not always move, but it will trend, pause and will move again. Using the zero line crossovers together with the markets' patterns (not price's patterns) is the key to making better trading decisions. The subject of waterline is one the hottest topic amongst successful swing and day traders.
No “indicator” can replace the price, and no serious trader should trade the indicators. The price is the number one indicator but “MACD” is an excellent price's repeater and trading “tool“. To operate this oscillator more efficiently, one must first learn to understand it and verify its signals with the price, to filter out false signals. Can one rely on MACD?