The Hustler's Digest StaffAn explanation of what the MACD trading indicator is and a guide to using the MACD as part of a day trading strategy.
MACD stands for moving average convergence divergence and is one of the most widely utilized momentum indicators in technical analysis. Gerald Appel created this at the end of the 1970s.
What is MACD?
The MACD indicator is a popular price indicator used for day trading and forex trading. It measures the difference between two exponential moving averages and plots the difference as a line chart. The difference between the MACD line and a second signal line is then plotted as an easy-to-interpret histogram.
By computing the difference between two time period intervals, a collection of historical time series, this indicator is used to comprehend momentum and its directional strength. MACD uses moving averages of two different time intervals (most commonly historical closing prices of securities). A momentum oscillator line is calculated by subtracting the two moving averages, also known as ‘divergence.’ The simple guideline is that one moving average should have a shorter period. The other should have a more significant period. In most cases, exponential moving averages (EMA) are used.
What is the MACD indicator?
One of the most often used technical analysis tools is the MACD indicator, the oscillator. The MACD has three main components. MACD: The difference between the 12-period and 26-period exponential moving averages (EMAs). Signal Line: The MACD’s 9-period EMA. The MACD minus the Signal Line is the MACD Histogram.
Calculation
The MACD line is the difference between the 12-day and 26-day Exponential Moving Averages (EMAs). These moving averages are calculated using closing prices. The indicator is plotted with a 9-day EMA of the line to operate as a signal line and identify turns. The Histogram depicts the difference between MACD and the signal line and its 9-day EMA. When the line is above its signal line, the Histogram is positive; when the MACD line is below its signal line, the Histogram is negative.
The standard parameters for the MACD are 12, 26, and 9, although other values can be substituted depending on your trading style and aims.
Interpretation
The name implies that the MACD is all about the convergence and divergence of the two moving averages. When the moving averages approach one other, this is known as convergence. When the moving averages move away from each other, this is known as divergence. The shorter (12-day) moving average is faster and is responsible for most fluctuations. The longer moving average (26-day) responds to price changes in the underlying securities more slowly and with less sensitivity.
Above and below the zero line, commonly known as the centerline, the MACD line oscillates. The 12-day EMA has crossed the 26-day EMA in these crossovers. Of course, the direction is determined by the direction of the moving average cross. The 12-day EMA is above the 26-day EMA, indicating a positive MACD. As the shorter EMA diverges further from, the longer EMA, positive values increase. This suggests that upward momentum is growing. The 12-day EMA is below the 26-day EMA when the MACD value is negative. Negative values increase as the shorter EMA diverges more below, the longer EMA. This indicates that the bearish trend is gaining traction.
The MACD line is negative in the yellow area in the example above, as the 12-day EMA trades below the 26-day EMA. It drifted further into negative territory as the 12-day EMA diverged farther from the 26-day EMA (black arrow) near the end of September (black arrow). When the 12-day EMA was above the 26-day EMA, the orange area indicated a period of positive values. The MACD line remained below one throughout this time (red dotted line). The difference between the 12-day EMA and the 26-day EMA was less than 1 point, insignificant.
MACD indicator formula
The MACD is a momentum-based trading indicator. This indicator can show changes in the speed of price movement and traders use to determine the direction of a trend. It is calculated by subtracting the 26-period Exponential moving average (EMA) from the 12 period EMA. This line is then plotted and this line is the MACD line.
A 9 day EMA of the MACD is then plotted on top of the MACD line and this serves as the line which can show traders the direction of the trend of the stock. The EMA is used as opposed to SMA (simple moving average) as the EMA incorporates recent price swings more.
Although a MACD can be plotted using a charting package, it is worth understanding how the MACD is calculated manually. The formula for the Exponential moving average is:
EMA = (today’s closing price *K) + (Previous EMA * (1 – K))
N = number of days in EMA
K (Smoothing Factor) = 2/(N+1)
Signal line crossovers
The most typical MACD signals are signal line crossovers. The MACD line’s signal line is a 9-day EMA. It trails the MACD as a moving average of the indicator, making it easier to notice MACD turns. When the MACD rises and crosses above the signal line, it is considered a bullish crossover. When the MACD turns down and crosses below the signal line, it is a bearish crossing. Depending on the severity of the move, crossovers can endure a few days or a few weeks.
Before relying on these typical indications, do your homework. Crossovers of signal lines at positive or negative extremes should be approached with caution. Chartists can estimate historical extremes using a simple visual examination despite the lack of upper and lower limits on the MACD. A big move in the underlying security must propel momentum to extremes. Even if the movement continues, momentum will most likely slow, resulting in a signal line crossover at the extremities. The underlying security’s volatility might also increase the frequency of crossovers.
Centerline crossovers
The second most prevalent MACD signal is centerline crossover. When the line crosses above the zero line to become positive, it is a bullish centerline crossing. This occurs when the underlying security’s 12-day EMA exceeds the 26-day EMA. When the MACD crosses below the zero line and becomes negative, it is a bearish centerline crossover. When the 12-day EMA falls below the 26-day EMA, this occurs.
Centerline crossovers might last a few days or a few months, depending on the trend’s strength. As long as there is a continuous upswing, the MACD will remain positive. When there is a long-term decline, the MACD will remain negative. In nine months, Pulte Homes (PHM) has had at least four centerline crosses. The resulting signals worked well because significant trends evolved with these centerline crossovers.
Unlocking the Power of Divergences in MACD Trading
Divergences occur when the MACD diverges from the price action of the underlying security, providing valuable insights for traders. In a bullish divergence, the security forms a lower low while the MACD forms a higher low, indicating a potential reversal from a downtrend. This suggests that although the security confirms a downtrend, the MACD signals decreasing downside momentum. Such a scenario often precedes a trend reversal or a significant rally.
An example of a bullish divergence occurred in October-November 2008 with Google (GOOG). By analyzing closing prices and observing clear response lows in both Google’s price action and its MACD Line, traders identified a bullish signal. While Google formed a lower low, the MACD showed a higher bottom in November, signaling a divergence. This was further confirmed by a signal line crossover in early December, followed by a breakout above resistance, indicating a reversal.
Conversely, a bearish divergence occurs when the security forms a higher high while the MACD forms a lower high, suggesting a potential reversal from an uptrend. Despite the security’s upward momentum, the decreasing momentum indicated by the MACD may foreshadow a trend reversal or a significant decline.
It’s essential to approach divergences with caution, as they may not always signal a reversal. In strong uptrends, bearish divergences are common, while positive divergences are expected in substantial declines. This is because uptrends often begin with a burst of upward momentum that gradually wanes, even as the trend continues. Similarly, at the start of a significant downtrend, the opposite phenomenon occurs.
Understanding and leveraging divergences in MACD trading can provide traders with valuable insights into potential trend reversals and market dynamics. By carefully analyzing these signals alongside other technical indicators, traders can make more informed trading decisions.
Using with sharp charts
The MACD can be used as a price plot indicator above, below, or behind an investment. Putting the MACD “behind” the price plot makes it easier to compare momentum and price fluctuations. The default parameter setting appears after selecting the indication from the drop-down menu (12,26,9). To increase or decrease sensitivity, these parameters can be tweaked. The MACD Histogram can be included with the indicator or added separately. The Histogram and the signal line will be removed if the signal line is set to 1 or left blank, i.e. (12,26,1) or (12,26). Choose “Exp. Moving Average” from the Advanced Options Overlays menu to add a distinct signal line without the Histogram.
Suggested scans
Here are some sample scans that StockCharts members can use to scan for various MACD signals:
MACD bullish signal line cross
Stocks that are trading above their 200-day moving average and have a bullish signal line crossover in MACD are identified in this scan. It’s worth noting that MACD must be negative for an upturn to occur after a retreat. This scan is merely a starting point for additional development.
MACD bearish signal line cross
This scan identifies equities with a bearish signal line crossover in MACD and trading below their 200-day moving average. It’s worth noting that MACD must be positive for this drop to occur after a rebound. This scan is merely a starting point for additional development.
How to read MACD?
There are two essential ways to read this indicator.
- Whether the market is overbought or oversold
- Whether the market is up-trending or down-trending ( A signal line crossover happens when the MACD line crosses below or above the signal line on the histogram. It can either be a bearish divergence or a bullish signal)
Overbought/oversold ( Buy and sell signals)
This is a snapshot of the MACD indicator in its FlowOne trading platform configuration. Peaks in the indicator correspond to price peaks, whereas toughs in the indicator correspond to price troughs.
This is because it tends to bounce between being overbought when it reaches a peak and oversells when it reaches a low.
The MACD indicator can show traders when the price is about to produce a high or low, helpful information for traders. Traders should cut long holdings around peaks and add to short positions, while short positions near lows should be reduced and long ones added to. Therefore, you must understand the divergence.
Uptrend or downtrend
The MACD does not have a -1 to +1 range like some technical indicators, but a zero line runs through it. When it is above zero, the trader can assume that the price is in an uptrend (bullish divergence). When it is below zero, the trader can believe that the price is in a downward trend (bearish momentum).
This information on MACD divergence can be used as part of a trading strategy to determine market direction. Traders that use a trend following method will only purchase when the line passes above the zero line, whereas mean reversion traders will only sell. Similarly, trend followers would want to sell if it is below zero, and counter-trend traders would be looking for trading opportunities to buy.
Ways to interpret the MACD index
The MACD indicator is a handy tool. The technical analysis indicator can be interpreted in three ways, explored in the three sections: Crossovers of Moving Averages Histogram of the MACD Divergences in the MACD How to Interpret MACD Crossovers of Moving Averages Moving average crossovers are the most common way to interpret the MACD. A possible buy signal is formed when the shorter-term 12-period exponential moving average (EMA) crosses above the longer-term 26-period EMA.
Important: The difference between short-term and long-term moving averages is that short-term MAs are used to find the moving average for smaller time frames, whereas long-term MAs are used for more extensive time frames. The primary function remains the same.
The 12-period and 26-period EMA construct the MACD line (blue line). As a result, the MACD line crosses above the zero line when the shorter-term 12-period EMA crosses over the longer-term 26-period EMA. The MACD line crosses below zero when the 12-period EMA crosses below the 26-period EMA. How to Identify Buy Signals Using Moving Average Crossover When the MACD (blue line) passes above the zero line, a possible purchase signal is formed.
How to Identify Sell Signals Using Moving Average Crossover A possible sell signal is generated when the MACD crosses below zero. The previous potential buys and sells signs could lead to trade later in a stock’s or future’s movement.
How to trade using MACD?
Because there are two different “speeds” of moving averages, the faster one will react to price movement faster than the slower one.
The faster line (MACD Line) reacts first when a new trend emerges, crossing the slower line (Signal Line).
When this “crossover” occurs, and the short line begins to “diverge” or move away from the slower line, it usually signals the emergence of a new trend.
The short line passed under the slow line, indicating a new downtrend had begun.
Remember, the indicator consists of three components:
- The MACD Line represents the difference between two moving averages.
- The Signal Line is a moving average of the MACD Line.
- The Histogram is a graphical representation of the distance between the MACD Line and the Signal Line.
That said, it is still one of the most favored tools by many traders.
An example MACD trading strategy
The rules of any day trading system must be clearly defined and easy to follow. This system is known as the MACD crossover. The rules for this example trading system are as follows:
- LONG/SHORT: Take long MACD signals when the price is above the 200 periods moving average
- ENTRY: Buy when it crosses over the zero line
- EXIT: Sell at a profit or loss when it crosses below the zero line
This technique is designed to buy when the MACD confirms that the price is transitioning from a down-trending to an up-trending situation. It then seeks to ride the rally for as long as possible before selling when the MACD indicates the price is heading back down. There’s also the requirement that the price is above the 200-period moving average to avoid trading in the opposite direction of the significant trend.
This is a sketch of a trading strategy that leaves out important details like which markets and timeframes to trade and risk management rules like cutting losses over a specific size. Any market, timeframe, or risk management method can be used with this strategy.
Drawbacks of using MACD
Each of the two ways of interpreting the MACD has its disadvantages.
- The price is generally well above the bottom when the MACD crosses above the zero line. When it crosses below the zero line, the top has already occurred. Using the MACD zero level as a price indicator is a lagging indicator, meaning the indicator signal arrives after the price has changed direction.
- When the MACD reaches an overbought level, the price is likely to remain in an uptrend for a long time. When it reaches an oversold level, the downtrend can extend for more time.
Waiting for the MACD to go overbought or oversold for a second time – generating its double top – is one technique to offset the drawbacks. Alternatively, as in the following example approach, you can only trade in the direction of a longer-term trend. Because it is a short-term indicator, you can also utilize other technical analyses.
Conclusion
The MACD indicator blends momentum and trend into a cohesive tool, applicable across various timeframes such as daily, weekly, or monthly charts. Typically configured with a 12- and 26-period Exponential Moving Average (EMA) difference, users can adjust settings for heightened sensitivity. For instance, employing a shorter-term moving average alongside a longer-term one increases responsiveness. The MACD(5,35,5) configuration, renowned for its sensitivity, proves particularly apt for weekly chart analysis. Conversely, elongating the moving averages dampens sensitivity, reducing the frequency of centerline and signal line crossovers.
Notably, the MACD’s utility lies in its limited ability to identify overbought and oversold conditions. While it may historically pinpoint extreme levels, it lacks definitive upper or lower bounds, potentially overshooting prior extremes during robust market movements.
It’s crucial to recognize that MACD values hinge on the underlying security’s price dynamics, affecting its interpretability. For instance, a $20 stock may yield MACD readings ranging from -1.5 to 1.5, whereas a $100 stock could span from -10 to +10. Consequently, comparisons across securities with varying prices prove futile. In such cases, opting for the Percentage Price Oscillator (PPO) offers a more reliable means of comparing momentum readings.
In conclusion, the MACD indicator, with its fusion of momentum and trend, serves as a versatile tool for traders and analysts alike. While its limitations in detecting overbought and oversold conditions are evident, understanding its sensitivity adjustments and complementing it with suitable alternatives like the PPO can enhance analytical precision in navigating financial markets.
