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
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
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.
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.