As traders, one of the first steps we take in understanding the market is studying its moving averages and the signals they give us. The Moving Average Convergence Divergence (MACD) is one such indicator that is widely used by traders to gauge the direction of the market in the short term. Unfortunately, as with all technical indicators, the MACD can prove unreliable. When this occurs, traders need to take specific steps to ensure they are still operating correctly and making informed trading decisions.
The MACD is, basically, an oscillator created by taking the difference between two Exponential Moving Averages (EMAs) of varying lengths – typically 12 and 26 days. The difference between the EMA’s is then plotted to easily visualize any changes in the difference; if the lines have converged, it is assumed the market is bearish, but if the lines diverge it is assumed the market is bullish.
When the MACD is broken, it usually means that the underlying trend in the market has changed, and as such, the signals the MACD has been providing have become unreliable. In order to mitigate any potential losses due to false signals by the MACD, traders need to take specific steps when the MACD is broken:
First, traders should look to confirm that the MACD is indeed broken. This is done by analyzing the trading volume within the period of time in which the MACD is broken – as there are usually increases in trading volume in certain periods of time, and the MACD can often follow these movements; if this is the case, then the MACD may simply be responding to a new trend. If trading volume is not a factor, or if the MACD is showing a consistent downward or upward trend without responding to volume changes, then it is very likely that the MACD is broken.
Once the trader has confirmed that the MACD is broken, they should look to supplement the MACD with other technical indicators that can help better understand the underlying market. For example, the Stochastic Oscillator or Relative Strength Index (RSI) can provide more detailed signals about the trend of the market. These indicators are generally good at confirming the direction of the market and helping to limit the risk of losses due to unreliable MACD signals.
It is also important to remember that the MACD is still valuable, even when it is broken. Although the signals it provides may not be as reliable, the MACD can still provide insights into how the market is trending in the short term, as well as giving traders an idea of where the market may be headed in the future.
In order to best understand the market and make informed trading decisions, traders need to be aware of the potential of the MACD breaking. By following the steps outlined above, traders can be better equipped to make informed decisions and limit their risk of losses due to incorrect signals from a broken MACD.
