Moving Average Convergence/Divergence (MACD) is a technical indicator that helps investors identify price trends, measure trend momentum, and pinpoint market entry points for buying or selling. The MACD is a trend-following momentum indicator that illustrates the relationship between two exponential moving averages (EMAs) of a security's price. Gerald Appel developed MACD in the 1970s, demonstrating his expertise and knowledge of the field.
Appel understood the importance of accurately measuring the momentum behind well-defined trends in order to achieve trading success. It can be challenging to discern the underlying trend due to price fluctuations and market volatility. Identifying market trends, such as recessions and other phases of economic cycles, is often easier in hindsight than in real-time.
Appel developed the Moving Average Convergence/Divergence (MACD) indicator to effectively identify trends, gauge the momentum behind them, and generate trading signals based on points of trend acceleration. Appel asserts that the MACD indicator is a versatile tool suitable for use in any market condition.
Understanding the Moving Average Convergence/Divergence (MACD)
The MACD is a technical analysis indicator that helps identify changes in a share price's momentum. The MACD gathers data from various moving averages to assist traders in identifying potential opportunities near support and resistance levels.
Convergence refers to the situation where two moving averages are approaching each other, while divergence occurs when they are moving in opposite directions.
The MACD indicator consists of three components:
- The MACD line calculates the difference between two moving averages.
- The signal line is a critical indicator for detecting shifts in price momentum and serves as a trigger for buy and sell signals.
- The histogram represents the difference between the MACD and the signal line.
When calculating the MACD, two lines are considered: the MACD line and the signal line. We derive the MACD line from the difference between the 26-period moving average and the 12-period moving average. The signal line represents the MACD's nine-period moving average.
A histogram displays the MACD, visually representing the distance between the two lines. When the MACD cuts through the signal line from below, traders may consider using it as a buy signal. Conversely, if it cuts the signal line from above, traders may view it as a sell signal.
MACD Divergence
When the MACD forms highs or lows that exceed the price's corresponding highs and lows, we refer to a divergence. When the MACD shows two consecutive rising lows that align with two consecutive falling lows on the price chart, there is a bullish divergence. This is a strong bullish signal when the long-term trend remains positive.
Some traders may consider bullish divergences even in a negative long-term trend, as they can potentially indicate a shift in the overall direction, although it is important to note that this approach is not always dependable.
When the MACD forms a series of two falling highs that align with two rising highs on the price, a bearish divergence emerges. In the midst of a long-term bearish trend, a bearish divergence confirms the expected persistence of the trend.
Traders often keep a close eye out for bearish divergences when there are long-term bullish trends, as these can indicate potential weaknesses in the overall trend. However, it is not as dependable as a bearish divergence during a bearish trend.
How is Moving Average Convergence/Divergence used in trading?
Traders utilize MACD to pinpoint shifts in the direction or intensity of a stock's price trend. MACD may appear complex initially as it relies on additional statistical concepts like the exponential moving average (EMA). MACD, on the other hand, is a valuable tool for traders to identify potential shifts in a stock's trend based on recent price momentum. This can assist traders in determining the optimal timing for entering, increasing, or exiting a position.
When the MACD experiences rapid rises or falls, indicating that the shorter-term moving average is diverging from the longer-term moving average, it suggests that the security is either overbought or oversold and is likely to revert back to normal levels in the near future. Traders frequently incorporate this analysis with the RSI or other technical indicators to confirm overbought or oversold conditions.
Investors often utilize the MACD's histogram in a similar manner as they would the MACD itself. Investors identify positive or negative crossovers, divergences, and sudden increases or decreases. Prior experience is crucial in determining the optimal choice for any given situation, as there are timing variations between signals on the MACD and its histogram.
Note the moving averages, specifically the MACD and the signal line, and how they relate to the histogram.
Note that the bars in the histogram are also above the zero line when the MACD line (the faster moving average) is above the signal line. This indicates a bullish signal. When the MACD line falls below the signal line and the histogram bars dip below the zero line, it typically indicates a bearish trend.
Some traders interpret bullish crossovers as buying opportunities, while negative crossovers serve as signals for selling or shorting. Different perspectives can approach the interpretation of crossovers. Similar to many technical indicators, utilizing the MACD involves a combination of artistic intuition and scientific analysis. First, try experimenting with it to see how it fits into your buying and selling strategy.
What Is a MACD Bullish/Bearish Divergence?
In a MACD positive (or bullish) divergence, the MACD doesn't reach a new low even though the stock price does. We refer to this as a "positive/bullish divergence" because it is a bullish trading signal.
If the opposite scenario occurs—the stock price reaches a new high, but the MACD fails to do so—this would be considered a bearish indicator and referred to as "negative/bearish divergence." The setups in both scenarios suggest that the upward or downward movement is unlikely to persist, prompting investors to explore other technical studies like the relative strength index (RSI).
Advantages and disadvantages of using the Moving Average Convergence/Divergence
The MACD indicator's main advantage is its ability to help determine trend direction, measure trend momentum, and identify potential market entry points for buying or selling stocks or other tradable assets.
In addition, you can predict the dependability of your buy and sell signals by analysing the spacing between the crossovers and the zero line on the histogram.
The MACD indicator is highly popular due to its simplicity and reliability. This is popular because it provides two distinct signals: the strength of the trend and the turning point of the trend. The MACD not only determines the direction of a trend but also assesses the strength of buy and sell signals.
Traders often opt for a simple moving average strategy to establish their buy and sell signals. However, it's crucial to acknowledge that this approach may lead to delayed responses, potentially causing changes in market conditions by the time of trade execution. We widely use the moving average convergence/divergence indicator because it provides a current depiction of market activity.
One major benefit is the ability to customize the MACD for various chart time frames, making it a flexible tool for both short-term and long-term trades.
MACD, like other indicators, has limitations and should be used with other technical analysis tools.
A possible disadvantage is that the MACD primarily focuses on short-term trends, with the longest measurement being the 26-day moving average. If a trader has a more extended perspective than this, the MACD may not be appropriate.
Another possible drawback is that the MACD functions as a trend-following indicator. The indicator provides signals as the trend is happening, rather than predicting it in advance. To predict a trend, the MACD may not be the best indicator.
One drawback of the MACD is that it has the potential to lag due to its reliance on moving averages and past data. Disclaimers often mention that past performance does not predict future outcomes. Similar to other technical indicators, the MACD might not respond quickly to current market conditions. During periods of rapid market shifts, MACD signals can lag behind.
Unfortunately, MACD performance is weak when the market is not trending. When there is no trend or when prices are moving within a range, you might receive a number of false signals with this indicator, as it is designed to follow trends. It can be quite frustrating to try to predict when prices are about to enter a range-bound pattern.
Conclusion
The subjectivity of MACD's versatility as a technical tool is what sets it apart. In different contexts, interpretations may vary, which can lead to errors, misunderstandings, and confusion.
Once you grasp the concept of reading the MACD indicator, it provides a visually captivating overview of market trends and momentum, allowing you to anticipate potential shifts.
MACD is a moving average that is most effective when used with daily data. Similar to how the intersection of the nine- and 14-day SMAs can create a trading signal for certain traders, the intersection of the MACD above or below its signal line can also generate a directional signal. The MACD indicator relies heavily on exponential moving averages (EMAs) that give greater importance to recent data.
As a result, it has the ability to swiftly respond to shifts in the current price trend. It is important to pay attention to crossovers of MACD lines, but it is also advisable to seek confirmation from other technical signals, such as the RSI, or maybe a few candlestick price charts. Since it is a lagging indicator, MACD suggests that it is important to wait for confirmation in subsequent price action before acting on the signal.
