What is MACD?
MACD, or Moving Average Convergence/Divergence, is one of the most basic yet effective indicators that most traders use in one form or another in their analyses. The MACD comprises of three major components. The main MACD line is the difference between a fast moving exponential moving average (EMA) and another slow EMA for a particular security. The signal line, is an EMA of the MACD line itself. Lastly, the divergence series represents the difference between the two, and is displayed as a histogram oscillating zero line. First created by Gerald Appel in the 1970s, The standard MACD(12,26,9) carries the numbers which represent the days corresponding to each of the 3 EMA series. These period settings are carried over from the days when daily charts were more commonly used, and even today it is most commonly used on daily charts.
The MACD is a very versatile and powerful tool in the hands of a trader. It can not only measure direction and momentum of market sentiments for a particular the instrument measured, but can also show the magnitude of price movement. There are typically a few events that can occur when using the MACD, each of which can aid a trader in trading decisions. Let us take reference to the standard MACD(12,26,9) and all notable events and their interpretations.
MACD Zero Crossover
The first thing to read off the MACD, is when the main MACD line is above the zero line. This means that the 12-day EMA is above the 26-day EMA. This corresponds to an upward momentum in price. The converse is also true; when it falls below the zero line, there is a downward momentum in price. Each time a crossover of the zero line occcurs, there is a change in the direction of price momentum.
Signal Line Crossover
The signal line is a more sensitive 9-day EMA of the MACD line, which is very sensitive for price momentum than the main MACD line. Whenever the MACD crosses over the signal line, it represents bullish sentiments while the opposite represents bearish sentiments.
A divergence occurs when the MACD diverges from the price action. A bullish divergence occurs when a security hits a lower low while the MACD line forms a higher low. The lower low in the security affirms the current downtrend, but the higher low in MACD represents reduced downward momentum. While momentum is still downward, reducing downward momentum can sometimes foreshadow a reverse in trend. The direct opposite is also true, when the price of the security forms a higher high while the MACD forms a lower high, it represents a decline in upward momentum and may foreshadow a downward rally.
The histogram itself can be used to gauge the strength of a particular trend, simply by observing the height of the histogram bars. The length of a particular bar for a time period can often reflect the magnitude of a momentum, and when coupled with other indicators such as RSI (Relative Strength Index), it can help to identify overbought or oversold levels on a security, which will usually be followed by a correction in price.
Precautions When Using MACD
There are a couple of main precautions when utilizing the MACD to supplement trading decisions. The first is to always remember that the MACD is a moving average of historical prices, which is always lagging behind the current price. Timing is always very important when making buying or selling decisions, as you might mistakenly enter a position after the momentum indicated by the MACD is already lost. Also, as with all indicators, the MACD is not infallible and can occasionally result in false signals. This is when all signs on the MACD indicate a trend reversal but price continues in the current upward or downward trend, or when it indicates a continuing trend but a reversal occurs.
MACD is a very useful indicator that is easy to learn and understand. As long as you do not over-rely on it alone, when used in conjunction with other analytical tools, MACD can be the most powerful tool in a trader’s belt. Learn to use it wisely!