MACD

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Introduction

Moving Average Convergence-Divergence (MACD) is one of the most popular momentum indicators used by traders. The MACD takes 2 moving averages and turns them into a momentum oscillator by subtracting a longer period moving average from the shorter period moving average. What makes the MACD unique among oscillators is that it can also be used to either as a trend following tool or momentum indicator. The most typical signals monitored traders are: signal line crossovers, centreline crossovers and divergences. Because the MACD is an unbounded oscillator it is not particularly useful for identifying overbought and oversold levels.

The MACD was invented by Gerald Appel in the 1970's and in 1986 Thomas Aspray added a histogram to the MACD as a means to anticipate MACD crossovers.

The MACD is considered a trend-following tool because of its use of moving averages. By subtracting the longer period moving average from the shorter period moving average, the MACD is transformed from a lagging indicator into a momentum oscillator. The MACD oscillates above and below zero, without any upper or lower bounds.

Formula

  1. MACD: EMA [fast, 12] – EMA [slow, 26]
  2. Signal Line: 9-day EMA of MACD
  3. MACD Histogram: MACD – signal

In the standard MACD formula traders use the 26-day Exponential Moving Average EMA minus the 12-day Exponential Moving Average (EMA). Closing prices are used for these moving averages. A 9-day EMA of MACD indicator is plotted as a signal line and is used to identify turns. The MACD-Histogram is the difference between MACD and its 9-day EMA signal line. When the histogram is positive the MACD is above its 9-day EMA and the MACD is negative when MACD is below the 9-day EMA signal line.

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Indicator Interpretation

One interesting aspect of the MACD is the use of an exponential moving average to offset some of the lagging weakness of the simple moving average (SMA) indicator by weighting more recent prices more heavily. By giving more weight to recent prices the MACD is designed to smooth out the effects of price volatility and allow analyst to detect changing price trends. EMA is also designed to reduce the drop off effect of volatile data found in SMAs.

The three most meaningful signals generated by the MACD indicator are the 1. MACD line crosses the signal line, 2. MACD crosses the zero line and Divergences.

The MACD line crosses the signal line

Signal line crossovers are the primary too provided by the MACD. When the MACD line crosses up through the signal line a buy signal is generated. This upwards move is called a bullish crossover. When the MACD crosses down through the signal line a sell signal is generated. This downwards move is called a bearish crossover. Together they indicate when the trend in the stock is weakening or about to change in the current direction of the trend.

Because MACD uses moving averages and moving averages lag price, traders can use the MACD-Histogram to reduce the delay of the indicator. The MACD Histogram can be used to anticipate signal line crossovers in MACD. As with MACD, the MACD-Histogram is designed to identify divergence and crossovers. The MACD-Histogram measures the distance between MACD and its signal line. Essentially the histogram is an indicator of an indicator. The histogram shows when a crossing occurs.

The MACD-Histogram is easier for trader to see when the two EMA lines are approaching a crossover. The changing sizes of the difference indicate acceleration or deceleration of a trend. A widening histogram informs traders that an ongoing trend is getting stronger. A narrowing histogram alerts us that a crossover may be approaching and thus a possible change in the direction of the current trend.

 

On the above chart of RIO we can see buy signal noted when the MACD line in black crosses through the signal line. A careful examination of the chart illustrates how the MACD lags the price action. Note how MACD crossover signal is about 5 days after the RIO made a swing low. By monitoring the histograms convergence toward the zero line, traders could have a “heads up” on the pending trend reversal.

 

Sell Signal is indicated by a bearish crossover of MACD line through the sell signal.

The MACD line crosses zero

A crossing of the MACD line through zero from positive to negative is considered bearish and from negative to positive is bullish. A crossover through the zero line can confirm that the direction of a trend is changing. Zero crossovers are not as helpful identifying changes in momentum.

 

In the chart of ABT we see how why the crossover of the zero is be more reliable confirming a change in trend then signalling the change. The MACD line crossover and MACD histogram happen several days before the MACD crosses through the zero line.

Divergence between the MACD line and price

Divergence between the MACD line and the price action of a stock is considered to be many technicians as one of strongest signs of pending change in the direction of a trend. Divergence is visually identified when MACD line and the graph of the stock price move in opposite direction. Positive divergence between the MACD and price occurs when price hits a new low, but the MACD doesn't. This is interpreted as bullish, signalling that a downtrend may be over. Negative divergence is when the stock price hits a new high but the MACD does not. This is interpreted as bearish, signalling that recent uptrend may not continue for long.

Divergence not only happens between the MACD line and price, it can also occur between price and the MACD-Histogram. If new high price levels are not confirmed by a new high on the histogram this is considered bearish. Conversely, if new low price levels are not confirmed by new low on the histogram, this is considered bullish.

Longer and sharper divergences that occur at distinct peaks or troughs are considered as more significant than occur with small and shallow divergences.

 

Conclusion

The MACD indicator is a popular tool in technical analysis because it gives traders the ability to quickly and easily identify the direction of the short-term trend. The MACD provides clear signals that traders can make systematic decisions involved in trading. The MACD allows traders to quickly identify the direction of the current trend and gauge if the momentum of the current trend is weakening or strengthening.