Moving average convergence divergence (MACD) is an oscillator-style technical indicator developed by technician Gerald Appel in the 1970s. Over time, it has become one of the most popular technical analysis tools among traders, who have found it useful in several different types of situations.
As its name implies, MACD displays the difference between exponential moving price (EMA) averages. It can be used in both range trading and trend trading, and has also been found to be particularly helpful in identifying entry points. The construction of the indicator is somewhat complex, but it has revealed itself to be convenient to use.
How Is The MACD Built?
The MACD is designed to quantify the potential direction and strength of a future price movement. Although similar, the MACD differs from other oscillators such as the relative strength index (RSI), which directly labels a market as being overbought or oversold. The RSI does this on a scale of 0 to 100, with overbought (70-100) and oversold (0-30) conditions having distinct numerical values. Comparatively, the MACD places price action into context visually by plotting multiple moving average lines on a graph.
Functionally, the MACD combines multiple simple moving average (SMA) and EMA values with an easy to read histogram. In total, there are four main components of the MACD indicator.
1. MACD Line
The first is the MACD line, which is frequently calculated according to the difference between 26-period slow moving averages and 12-period fast exponential moving averages. Although the 26-period and 12-period EMA durations are the MACD's default settings, it is possible to customise periodicities according to personal preference. Typically, users can alter periodicity seamlessly through their charting software platform.
A simple moving average is determined by adding closing prices for a series of periods and then dividing the total by the number of periods.
A period exponential moving average is similar to a period simple moving average, except that it uses exponential weighting to give more weight to more recent closing price data. Thus, the most recent data gets the greatest weight, and the weight of each data point decreases exponentially moving back chronologically. In this way, a period's EMA is viewed as being a better reflection of current price action than its SMA.
2. Signal Line
The second component of the MACD chart is the "signal line" (also known as the "trigger line"), which is calculated using a nine-day exponential moving average of the MACD line itself. The signal line is considered to be a slower-moving picture of price action and is used as a basis of comparison for the MACD line.
3. Zero Line
A third component is the "zero line." It's a horizontal line across the chart that indicates the division between a positive price trend and a negative price trend. It also represents the point at which the MACD and the signal line cross.
Many trading strategies identify a forthcoming uptrend or downtrend via the zero line/MACD crossover. As a general rule, market sentiment is deemed positive (bullish) when the MACD is above the zero line and negative (bearish) when below.
A final component is the "MACD histogram." It's a representation of the magnitude of the difference between the MACD line and the signal line. It will appear as a two-dimensional, curved bar graph either above or below the zero line. The histogram furnishes users with a clear view of the MACD's standing with respect to evolving price action.
The rationale behind using the MACD is that by examining moving averages, it can reveal the momentum strength of a particular trend. In this way, the MACD functions as a momentum oscillator as it addresses the potential extension or exhaustion of a prevailing trend.
If prices are rising, the fast-moving 12-period average will increase at a faster pace than the slower moving 26-period average. Subsequently, the MACD Line will appear to move upward. If they are falling, the MACD line will slope downward.
How Is The MACD Used?
MACD is considered to be a versatile momentum indicator that can be used for objectives in trend trading, swing trading, and identifying entry and exit levels.
Trend Trading – Crossover, Divergence and Convergence
The different slopes of the MACD and signal lines are used to determine trend direction and momentum strength in trend trading. When observing the MACD chart, traders will see the two lines crisscrossing each other in a snake-like fashion over time. When the MACD line crosses above the signal line, it is understood as a bullish signal to buy.
According to this scenario, the market is expected to challenge or make a new high. Conversely, when the MACD crosses below, it is seen as a bearish signal to sell in anticipation of price action driving toward a new low.
The separation between the MACD and signal lines is understood to be an indication of the strength of momentum. Thus, the farther apart the two lines move in "divergence," the stronger the price trend is thought to be. When the lines narrow toward "convergence," the trend is understood to be weakening and pointing toward a reversal.
MACD is frequently incorporated into trend following strategies. However, in order to use properly, it's important to understand the difference between bullish and bearish divergence:
- Bullish Divergence: Bullish divergence occurs when the MACD makes two consecutive higher lows while price posts two lower lows. Many traders view this scenario as a bullish indicator and the precursor for a forthcoming uptrend in price action.
- Bearish Divergence: Bearish divergence develops when the MACD makes two lower highs in a row while price makes two higher highs. Accordingly, this event is often interpreted as a signal of a downturn in price action.
The degree of bullish divergence and bearish divergence is reflected in the size of the histogram. The taller the histogram image above or below the zero line, the stronger the trend. At the point where the histogram crosses the zero line, the trend is making a reversal. An upward histogram image above the zero line will indicate positive momentum, and a downward move will indicate negative momentum.
When using bullish or bearish divergence, it is vital to take the prevailing trend and market conditions into account. Both signals work best when utilised in concert with a prevailing bullish or bearish trend, not as standalone indicators.
Histogram: Early Indicator Of Reversal
One special advantage the MACD has over some other indicators is that it can provide an early indicator of reversal before it is actually confirmed by the moving averages crossing the zero line. This can be a helpful tool for both technical and fundamental analysts looking to identify trade entry and exit points. Also, the histogram can be especially useful for this purpose.
Traders can seek to buy just after the histogram reaches its lowest point, which will be a signal that precedes the upward crossover of the MACD with the signal line. Similarly, they can plan to sell after the histogram reaches its highest point, which will precede a downward crossover of the MACD with the signal line.
Avoiding False Signals
Given that markets can change direction at any moment, one concern among traders using MACD is to avoid entering trades based on false short-term signals. A method traders have found for minimising this risk is to only take trades in the direction of the trend, by comparing the signals shown by the MACD chart with a simple 200-day moving average. When the price is above the 200-day moving average, traders will consider only buy signals given by MACD. When it is below the average, they will consider only sell signals.
The MACD is more commonly considered to be a trend indicator, but it can also be used for range trading. As momentum is normally thought to be more significant for trend trading, range traders will want to concentrate on the buy and sell signals given by the histogram. They'll also want to watch for crossovers of the MACD and the signal lines to identify entry and exit points as price moves between support and resistance.
The MACD has become a favourite indicator for traders because it shows a variety of signals regarding trend, momentum and reversal—all on a single chart. The indicator is not entirely fool-proof. However, when used carefully, it can help traders try to make an early identification of where and how prices will be moving next.
This article was last updated on 18th October 2021.
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