MACD (Moving Average Convergence Divergence)

Introduction

It seems like there’s a technical indicator for just about any situation within the stock market. 

Whether it be bearish or bullish sentiments, breakouts, and whatnot, you can be sure that somewhere there’s a tool that could potentially identify that and allow you to transact to your benefit. 

While the possibility of false signals always remains for the most part, depending on the stakes, the advantages usually outnumber the negatives.

One such indicator that we’ll be looking at today happens to be a rather popular one, i.e., the MACD, short for moving average convergence divergence.

What is MACD (Moving Average Convergence Divergence)?

So, what is the moving average convergence divergence, aka MACD? Well, it happens to be a technical indicator helping investors with the identification of various interests. Gerald Appel is the man behind its creation, and he made it all way back in the 1970s.

The Purpose of MACD

But what’s the MACD actually made for, i.e., what’s its purpose? Simply put, it’s meant to help identify price trends, the market entry points regarding purchasing and selling, and measuring trend momentum or reversals within the stock market, like when a significant move is underway. 

In addition to that, it also displays the relationship between two EMAs, or exponential moving averages, of a stock’s price. 

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Components of the MACD Indicator

So you know a bit of what the MACD is. Still, that’s not all there is to it obviously, which is why below we’ll be discussing its primary components, namely the MACD Line, the Signal Line, and the MACD Histogram, which is charted across the baseline, a horizontal axis. 

Usually, the MACD chart is graphed below a stock’s price chart, enabling price movements to be compared with alterations within the MACD chart.

MACD Line

The MACD line’s calculation involves subtracting one long-term EMA from a shorter-term EMA. 

Generally speaking, these include the 26-day and 12-day EMA, calculated depending on the closing price of each day. In other words, it tracks the distance between those two MAs.

Signal Line

As for the signal line, that is calculated by acquiring that difference between those two EMAs we mentioned earlier and creating a nine-day MA from that number. 

It’s not needed to calculate such values yourself, as there are various charting software that simplify things with their back-testing capabilities, automatically preparing every calculation instantly for users. 

But what does it do, you might be wondering? Well, it’s responsible for identifying shifts in price momentum, acting as a sort of trigger for selling and buying signals.

MACD Histogram

Lastly, the histogram is calculated by subtracting the MACD and signal lines. 

This is simpler to discern than glancing at those two lines alone, as it can be challenging at times to determine if a curve is steeper or not. 

So, when the MACD is greater than the nine-day EMA, the histogram displays a positive signal. Likewise, it displays a negative when it’s lower. 

To summarize, the histogram shows the difference between the signal and MACD lines. Traders use it to look for possible price swings and trend reversals.

How to Use MACD in Trading

Now that the MACD explanations are out of the way, you might want to know how you can use the indicator to trade, which is precisely what this section seeks to cover.

MACD Line Crossovers

Here, a crossover happens when the MACD and signal lines cross one another. The MACD produces a bullish signal if it goes beyond its nine-day EMA. As for the bearish or sell signal, that’s generated when it goes below the nine-day EMA.

Zero Line Crossover

If the MACD crosses the zero line, i.e., from below it to above it, it’s regarded as a bullish sentiment. Traders typically conduct long positions whenever this happens.

 If it crosses in the opposite manner, though, from above to below, traders regard it to be a bearish signal, after which they take short positions to benefit from falling prices and rising downward momentum.

MACD Divergence

MACD divergence basically happens when an asset’s price and the MACD indicator diverge. This is regarded as a warning signal, indicative of a possible trend reversal. 

Bullish divergence happens when an asset’s price makes lower lows and the MACD indicator generates higher lows, which implies that while the asset’s price is going lower, the momentum underlying the price movement may actually be rising.

Bearish divergence, on the other hand, happens when an asset’s price generates higher highs while the MACD indicator generates lower highs. 

This indicates that though the price is rising, the momentum behind that movement might really be reducing.

MACD Strategies for Different Trading Styles

Let’s see how the MACD indicator could relate to and cater to some of the more popular trading styles, like day, swing, and long-term trading.

Day Trading with MACD

Like with any indicator, you can adjust the time frames according to your needs, so if you’re a day trader, you can make it suited for short-term gains, like triggering trades only when there is a significant surge in volume, for instance, besides the usual.

Swing Trading with MACD

For swing trading, which focuses more on medium-to-long-term gains, the time frames can be adjusted accordingly, and you can opt for a divergence strategy, which we already went through earlier.

Long-Term Investing with MACD

Those who are in for the long haul may make the time frames longer with more distance in between to suit their needs. As for a strategy that would fit such a style, zero-line crossovers may suffice.

Advantages and Limitations of MACD

Like any indicator out there, whether it be the RSI or an SMA, you can be sure that the benefits come with their share of drawbacks too, as we’ll discuss below.

Benefits of Using MACD

One of the more obvious advantages is how it’s good for identifying trends since it combines both trend and momentum in a unique way, allowing for some good buying and selling signals that anyone would appreciate. 

The other notable aspect has to be how it can detect divergence, another powerful tool that traders can have at their disposal. And lastly, it can work across different time frames, granting it that much-welcome flexibility.

Limitations of MACD

Among the more substantial drawbacks is how a reversal signal may turn out to be a false indicator. An example of that would be how sometimes the zero-cross has this point where the MACD might cross from below and then back again within one trading session. 

Then there’s the lack of functionality within sideways or choppy markets, where you see a tendency for the MACD to drift more to the zero line due to there being no down or up trend. 

Not only that, but the MACD zero-cross can be a lagging indicator since the price is usually above the earlier low before the MACD goes beyond that line from below. With this, you may end up entering a long position later than you could have.

Conclusion

MACD is among the most-utilized oscillators out there due to it being a dependable method for the identification of momentum and trend reversals. 

Including the ones we mentioned earlier, there are several strategies you may use with MACD as a trading indicator. 

So, try to look for something that best suits your needs or trading strategies. But as with anything, it’s important you factor in its drawbacks too and make up for them, like employing another indicator with it.