Moving Average Convergence Divergence (MACD) is a trend-following signal indicator that shows the relationship between two moving averages of security prices. The MACD indicator is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.
What is the MACD indicator?
MACD stands for Moving Average Convergence Divergence. This is a moving indicator that follows the price trend and shows the correlation between two moving averages of the price.
Gerald Apple developed the MACD indicator in the late 1970s. The effectiveness of this indicator has been tested over time and can be very beneficial for traders.
The MACD indicator consists of 2 lines : the signal line and a histogram. A histogram is used to show the difference between fast and slow-moving averages. Therefore, when the distance between the EMAs increases, the histogram increases. This state is called divergence. Conversely, the histogram decreases as soon as the moving averages are approached. This state is also called convergence. This explains why this indicator is called moving average convergence divergence.
What does the MACD measure?
MACD measures the strength of a move or trend using the MACD line and zero line as reference points: We will see a bullish signal when the MACD line crosses above the zero line.
Conversely, we see a bearish signal when the MACD line crosses below the zero line.
MACD Formula
MACD=12-Period EMA − 26-Period EMA
MACD is calculated by subtracting the long-term EMA (26 periods) from the short-term EMA (12 periods). The exponential moving average (EMA) is a moving average (MA) that places more weight and importance on the most recent data points.
The exponential moving average is also called the exponentially weighted moving average. An exponentially weighted moving average reacts significantly to recent price changes compared to the simple moving average (SMA), which applies equal weight to all observations in the period.
Interpretation of MACD
Whenever the 12-period EMA (marked by the red line on the price chart) is above the 26-period EMA (blue line on the price chart), the MACD has a positive value (shown as the blue line on the bottom chart). And a negative value when the 12-period EMA is lower than the 26-period EMA. The longer the MACD distance is above or below its baseline, the more the distance between the two EMAs increases.
The MACD is often displayed with a histogram that plots the distance between the MACD and its signal line. If the MACD is above the signal line, the histogram will be above the MACD baseline. If the MACD is below its signal line, the histogram will be below the MACD baseline. Traders use the MACD histogram to identify when a bullish or bearish trend is high.
Calculation of the MACD indicator
To calculate the MACD indicator, you need to use the exponential moving average.
The EMA is calculated by first calculating the Simple Moving Average (SMA) for the selected periods. To calculate a 12-period EMA, the calculation is simply the sum of the last 12 time periods divided by 12.
MACD calculation requires all EMA calculations as follows:
Calculate a 12-period price EMA for the selected period.
Calculate a 26-period price EMA for the specified period.
Subtract the 26-period EMA from the 12-period EMA.
Finally, calculate a 9-period EMA of the result obtained from step 3.
This 9-period EMA line on a histogram is created by subtracting the 9-period EMA from the result of step 3, which is called the MACD line but is not always visibly plotted on the MACD display on the chart.
MACD has a zero line to indicate positive and negative values. MACD has a positive value whenever the 12-period EMA is above the 26-period EMA and a negative value when the 12-period EMA is below the 26-period EMA.
MACD compared to RSI
The purpose of the power index is to show the entire buying and selling of an asset in a certain period. RSI is an oscillator that calculates the average price gains and losses over a given period. The default period is 14 periods with limited values from 0 to 100.
MACD measures the relationship between two EMAs, while RSI measures the price change between the recent high and low prices. These two indicators often give analysts a complete technical market picture.
These indicators both measure movement in the market, but they sometimes give opposite indications because they measure different factors. For example, the RSI may show a constant above 70 for a while, indicating that the market is overbought relative to recent prices, while the MACD suggests that the demand is still rising. In the rush to buy. Each of these indicators may indicate a change in the future trend by showing a divergence from the price (the price continues to move higher while the indicator moves lower or vice versa).
Limitations of the MACD indicator
The MACD indicator performs best in trending markets. This limits its use to traders depending on their trading strategies. For example, this indicator usually provides traders with faulty signals in limited markets. Novice traders may find this indicator challenging to use at first, which is why understanding the moving average and EMA principles will benefit traders looking to use the MACD indicator.
The changes that can be implemented with the MACD indicator are many and different for each trader. As a result, the results of using it vary from trader to trader, which destroys any consistency. Therefore, traders should follow a general plan when using MACD:
Selection of EMA parameters
Use an appropriate time frame, as MACD may behave differently in time frames.
How do traders use Moving Average Convergence Divergence (MACD)?
Traders use MACD to identify changes in the direction or strength of a stock price trend. MACD can seem complicated at first glance because it relies on statistical concepts such as the Exponential Moving Average (EMA). But basically, MACD helps traders identify when a recent move in a stock’s price may indicate a change in its underlying trend. This can help traders decide when to enter a buy or sell position.
What is the positive and negative divergence in MACD?
A positive MACD divergence is a situation where the MACD does not make a new low, despite the stock price making a new low. This trend is considered a bullish trading signal, hence the term “positive divergence.” Conversely, if the opposite scenario occurs, the stock price reaches a new high, but the MACD fails to do so; this is considered a bearish indicator and referred to as a negative divergence.
What are the best settings for the MACD indicator?
12, 26, and 9 days are the periods set in MACD default settings. However, this does not mean that these default settings will perform well in every time frame or every trading strategy. Therefore, it is recommended to try different options to find the best settings that suit your trading style.
Final word
MACD uses exponential moving averages to produce a popular momentum indicator, allowing technical traders to identify trends and reversals. All data used in MACD is based on historical stock price performance. However, some traders use the MACD histogram to predict when a change in trend will occur. For these traders, this aspect of the MACD may be considered a key indicator of future trend changes.
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