Understanding Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD)

In the simplest of terms, technical analysis tools help a trader foresee market movements. This helps them formulate trading strategies accordingly and try and earn profit.

While there are a lot of indicators that you can use here, moving average convergence divergence (MACD) is one of the most popular because of its effectiveness and simplicity.

Let us learn more about the moving average convergence divergence indicator and see how you can use it to get the best out of stock markets.

What is Moving Average Convergence Divergence (MACD)?

MACD is a technical indicator that allows you to gauge the momentum and strength of a stock’s price movement. As the name suggests, it uses moving averages to do the same.

what is macd

Moving average is calculated by taking the average of multiple price points in a certain time period. It shows the average price of the stock so that you can gauge where the current stock price stands.

Here, we look at how the different moving averages converge and diverge and try to find trade signals from them.

MACD technical indicator was founded by Gerald Appel, one of the legends in the field of technical analysis. The tool was first introduced around four decades ago, but it still remains one of the most popular and efficient.

One of the factors that make MACD different from most of the other indicators is that, while the name could make you think that it is complex, MACD remains one of the simplest technical analysis tools out there. Yet, it is spellbinding how efficient the tool still is.

How Does MACD Work?

MACD is a technical indicator that gives you two valuable pieces of information. It can give you an indication of the changes in price trends and help you gauge the momentum of price changes. Bullish divergence and bearish divergence gauged from the MACD indicator are also important.

They do this by comparing moving averages. Both these averages as marked as two lines – the signal line and the MACD line.

How Does MACD Work

The MACD line

MACD line is charted by subtracting a 26-period EMA (Exponential moving averages) with a 12-period EMA. This helps to form a line that is indicative of the recent trend. Let us take an example to understand this better.

Let us suppose you own a shop and were calculating the daily sales averages of the past few months. You wonder if there is a recent trend change in the sales numbers. For this, you took the average sales of the last 26 days and then subtracted them from the average sales of the past 12 days. Here, if you get a positive number, that means the average has gone up and vice versa.

Similarly, if the MACD line is in the positive territory, it indicates an uptrend and the MACD line in the negative indicates a downside territory.

SIGNAL line

Next is the signal line. It is the nine-day EMA of the MACD line. The same is used to compare the movement of the MACD line. Usually, MACD line and signal line crossovers give trade signals.

MACD Formula

There are two moving average lines to calculate here – the MACD line and the Signal line. They are calculated similar to what is mentioned above, but let us explore that in the form of an equation.

Here, MACD=12-Period EMA − 26-Period EMA

While Signal line = nine-day EMA of the MACD line

Here EMA can be found using the equation –

EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)

But most modern charts will give you an option to apply MACD by default for you to compare it along with the price chart. Let us see how the same will look in a chart.

MACD Indicator in a Chart

MACD Indicator in a Chart

The above is a price and MACD chart of Nifty 50 on a particular day. The chart on the upper side is a 1-minute candlestick price chart, and the one on the lower side is the MACD graph.

If we focus on the MACD indicator graph, there are three important factors visible. Here, the black line is the MACD line, while the red line is the signal line. In the middle, you can see a histogram. The line that goes through the base of the histogram indicates zero.

Now, let us take a closer look at the MACD indicator alone to understand it better.

macd histogram

As we have discussed above, the black MADC line is the difference between two EMAs. A positive difference here is indicated when the MACD line is above the zero line. Similarly, a negative difference between two EMAs is indicated when the MACD line is below the zero line. The same is visible in the graph above as well.

When it comes to the signal line, it tends to follow the MACD line on most occasions. Major trade signals are observed when the MACD line crosses the signal line. We will learn more in the next chapter.

Finally, there is the histogram. Here, when the MACD line is at zero, it indicates that the difference between the two EMAs is zero. The bars in the histogram are indicative of the difference between the MACD line and the signal line. A higher difference creates a longer bar, and a smaller difference creates a shorter bar. The length of the bar could be used to gauge the strength of the possible price or trend change.

How to interpret the MACD indicator?

As said above, the MACD indicator is helpful in indicating both trends and momentum. Here, the most important factor is the MACD line itself. The higher or lower the MACD line is from the zero line, the more the price has deviated from the average. Let us take a real-life example to understand this better.

How to interpret the MACD indicator

Above is the MACD graph of a particular stock. Look at the portion marked with a crosshair on the left-hand side. There you can see that the MACD line is near 50 points, which means the difference between the two EMAs is higher. This indicates a comparatively strong trend. Since the MACD line is above the zero line (the difference of averages is positive), it signals a positive trend.

Now, look at the area marked with a crosshair on the right-hand side of the graph. Here, the difference is only a mere ten, and hence the trend is comparatively weaker.

MACD Trading Strategies

Crossovers of the MACD line and the signal line is also informative. Let us look at how to use this to formulate strategies.

MACD and signal line crossovers

MACD indicator is a momentum oscillator, and the crossovers of the two lines provide buy and sell signals, similar to a stochastic oscillator. Similar to the case of a stochastic oscillator, a buy signal is observed when the more sensitive line crosses the less sensitive line. In the case of MACD indicator, the MACD line is the faster (more sensitive line), and the signal line is the slower one.

On the other hand, when the MACD line crosses below the signal line, traders see a buy signal. Let us take the help of a graph to understand this better.

MACD and signal line crossovers

The above graph of Sensex is an ideal example of a bullish crossover. If you look at the area marked with the crosshair, you can see that the price movement attains a bullish trend once there is a crossover.

Here, you could buy or take a long position, according to your strategy.

This chart shows the exact opposite of the above one. Here, the Sensex enters into a negative trend following the signal line crossover. You could enter a short position or sell your stocks at this point, according to your strategy.

Histogram reversals

The MACD histogram is one of the most useful parts of the indicator. As we have discussed above, the histogram is formed by calculating the difference between the MACD and the signal line. A higher difference here indicates a higher price action. Hence, a higher histogram bar can be attributed to a stronger trend. Take a look at the graph below to understand this better.

Histogram reversals

Here, there are two crossovers to pay attention to, marked by two crosshairs. The first crosshair signals sell, but the histogram bars after that are comparatively short. As a result, even though the signal turned out to be true, the trend was short-lived (comparatively).

Now, look at the second crosshair. Here, the crossover indicates a positive trend, and after that, there are higher histogram bars compared to the previous case. Because of this, the trend became stronger.

You can use this information to avoid false signals primarily. For instance, even if there is a crossover, if the histogram bars are unusually short, it could be a sign of a false positive signal.

Zero crosses

Zero crosses are probably the easiest to read but often the slowest. Here, the reading depends on either of the line crossing the zero line – the MACD or signal line crossing the zero line from the above indicates a positive trend, while either of the lines crossing the zero line from below indicates a negative trend.

But a zero cross is often the least used information from the MACD indicator. Hence, it is a good idea to use it as a trend-confirming tool rather than a tool to find the trend.

Identifying explosive breakout trades

Every stock has several support and resistance levels. The security’s price tends to stay between these levels due to support and resistance. Take a look at the below chart.

Identifying explosive breakout trades

Here, the line at the bottom is the support line (the red line above is the resistance line). You can see here that the price is finding it hard to breach the support line.

A breakout is when a trend becomes strong enough, and the price breaks either of these levels. An explosive breakout happens when the change is extremely big, and the movement happens within a matter of seconds.

Here, MACD histograms help in identifying explosive breakout trends. Look out for areas where the MACD histogram becomes almost flat for a considerable amount of time. This indicates low volatility as well. You should ideally use another indicator to confirm the same and find the trend direction.

Using MACD and RSI Together

Like every other indicator, MACD also works best when combined with other technical analysis tools. A relative strength index is one of the indicators that work well with MACD. Let us see how it can help.

MACD and RSI to confirm price momentum

Both MACD and RSI indicators are widely used to find momentum. Many experts believe that confirming the momentum MACD indicated with RSI often gives the best results. If both the indicators are not agreeing on the momentum, it is considered by many a false signal.

Finding the exit point

Both MACD and RSI are useful tools for finding entry points. But a combination of these can be used to find exit points as well. As said above, when both indicators are not in agreement, it may show the trend weakening. Hence, you could consider the point where MACD and RSI diverge as a possible exit point.

When to Use MACD?

Like with any other indicator, there is no perfect time period where MACD works the best. But make sure you keep an eye on the volume before you trade depending on signals from MACD since the averages are not volume-backed. Periods of lower volume may give you nonreliable signals. For instance, if there is only one trade that has happened in a day, it could affect MACD significantly, and the trend could change considerably when a higher number of trades happens.

Common Mistakes to Avoid While Using MACD

An indicator best works when you manage to avoid the usual mistakes that traders are prone to make while using them. Below are two of the most common mistakes while using the MACD indicator.

Not setting stop-loss

MACD is a very useful indicator. As said above, it may be even more useful when combined with another indicator like RSI. But that doesn’t mean it is foolproof. It could show false signals, like any other indicator. Hence, make it a point to set stop losses to limit the possible loss.

Trading the MACD crossover when the trend is not strong enough

The MACD and signal lines can crossover multiple times in a short interval, especially during periods of uncertainty. Hence, it is wiser to always confirm how strong the trend is before investing. One thing you could use here is the height of the histogram, as said above. But using another indicator may help you make a better finding.

Conclusion

Like with any other technical analysis tool, MACD also has its strengths and weaknesses. Usually, the best course of action is to use MACD for its strengths and cover the weakness with other technical indicators. Either way, financial markets could become a tough nut to crack. Hence, getting advice from a mentor or a financial advisor is often a wise decision.

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