MACD is an acronym used for moving average convergence divergence. It is a technical tool developed in the ’70s by Gerard Appel. His aim was to compare two exponential moving averages to chart momentum by measuring the relationship between them. Today It is one of the most effective and simplest momentum indicators available and used by analysts and traders.
The nature of momentum in the financial markets is similar to the momentum in the physical world. For example, if you take an apple and throw it in the air the apple will slowly ascend upwards until it reverses and falls back down. This the case in the financial markets. The price changes are most of the time preceded by changes in momentum. These changes in momentum can be traced easier with the use of MACD.
The MACD indicator is consisting of two moving averages (lines), the MACD and the signal line. It is used by traders and analysts to spot buy and sell signals in an asset. In addition, it can determine whether a stock price is considered to be overbought (expensive) or oversold (cheap). The one line needs to be longer and the other one shorter in order for the MACD to subtract the longer from the shorter one. Is worth noting that both lines are exponential moving averages lines. The shorter EMA is always converging toward or diverge away from the longer EMA.
MACD=12Period EMA-26Period EMA
It is often displayed in a histogram which graphs the difference between the MACD line and its signal line. If it is above the signal line, the histogram will be above the baseline. If it is below the signal line, the histogram is below the MACD’s baseline. Traders usually use the histogram how strong or powerful the bullish or bearish momentum is.
The result of the calculation after subtracting the longer(26-period) from the shorter(12-period) one is called the MACD line. The 9-day EMA of the MACD is called the signal line. The signal line is then plotted on top of the line, which can act as a trigger for buy and sell signals. Traders and users, in general, may buy the security when MACD crosses above its signal line.
Likewise, traders may sell or short an asset when the line crosses below the signal line. MACD lines can be interpreted in many different ways but the most known ones are crossovers, divergences, and rises/falls.
Note: MACD line generates short term buy and sell signals and not long term.
The definition of a crossover is a spot on a technical graph that is created when the price of security intersects with a technical indicator. Crossovers are estimates of potential breakouts or reversals in a price change trend. Crossover is one of the main moving average strategies. In other words, is when a price crosses above or below a MA to indicate a potential change signal in the price trend. You can find other MA strategies under the moving averages sector under our encyclopedia.
When the MACD is in a position so that the prices formed are different from the corresponding lowest and highest prices, it is a matter of divergence.
When the MACD makes two rising lows that correspond to two falling lows, then it is a bullish divergence. That would be a relevant bullish signal in the case of a long-term trend that is still positive. It is considered a reliable technique.
Again, on the contrary, when MACD makes two falling highs that correspond to two rising highs, it is, you guessed it, a bearish divergence. This divergence that occurs during the long-term bearish movement is a reliable confirmation that the bearish trend will continue.
When the MACD indicator rises or falls rapidly meaning that the shorter moving average is pulling away from the longer one, it gives a signal of overbought or oversold security that will soon go back to normal. This analysis is usually used in combination with the RSI indicator to confirm the overbought or oversold conditions. The RSI is necessary because it shows the securities price condition when for example a 70 RSI indicates an overbought situation.
Oscillators like MACD are more valuable when their value reaches extremes of their boundaries. If you think about it, MACD can theoretically fall or rise indefinitely.
If you were to apply extremes to the MACD indicator, (for example assume that the MACD line and the signal line are relatively far away from the zero line) the signals would be as follows:
Note: To gave you an understanding of extreme cases during the market selloff in March (when the pandemic hit the markets) the MACD line reached an extremely oversold suggestion of (i.e., under negative 200).
Traders that use the MACD line to identify trends, will also try to confirm the direction of the trend. This will be clear if the MACD indicator is making higher highs or lower lows in conjunction with the price. This sort of confirmation is often called a confirmation of the divergence.
As most of the technical tools used for chart analysis, the MACD indicator should not be used alone. Instead, it should be used in combination with other indicators or technical tools to form a more accurate and not confusing market opinion and therefore investment decision. Can it go wrong?
The weakness of this indicator is false signals, as well as insufficiently reliable signals. Signals of a possible reversal may occur, but not a real one. It is the so-called false positive. Also, not all
reversals will be predicted. In short, this indicator could point to reversals that will not happen as well as insufficient actual reversals.
The MACD indicator, as said, is one of the most popular because it shows changes in the trend and also provides information about the momentum. It is monitored on a daily, weekly, and monthly basis. Usually, it represents the difference between a 12-period and a 26-period EMA, as said. Besides, MACD (5,35,5) can be used instead of the one we presented (12,26,9). The (3,35,5) set is more sensitive and more suitable for weekly charts. When traders ask for less sensitivity, they can extend moving averages.
