Summary - Most successful traders who practice technical analysis have their preferred indicators. Although no indicator can ever guarantee a successful trade, the use of indicators can minimize risk by helping to improve the probability of success. One of the more simple and easy to understand indicators is the moving average convergence/divergence oscillator (MACD). MACD charts show the relationship between two exponential moving averages (EMAs). By subtracting the longer average from the shorter average, the MACD displays both the trend of the price action for the underlying security as well as the momentum of buying and selling activity. The companion to the MACD line is a signal line which is the 9-day EMA for the asset being used. The MACD is a momentum oscillator that moves above or below a center line (also called a zero line). Traders will look for signal line crossovers, centerline crossovers, and divergences between the MACD line as triggers for buying and selling. One of the limitations to the MACD oscillator is that it is unbound, which means that it is not considered a stand-alone indicator for determining whether an asset is overbought or oversold.
Moving averages are one of the bellwethers used by traders of all experience levels. One reason for this is that averages are simple enough to understand and part of our daily experience. As students, we had grade point averages, we evaluate athletes by per season or per game averages, the success of a movie is based on a box office average. To sum it up, averages help us understand when something is overperforming (above average) or underperforming (below average).
In reference to stocks and other asset classes, averages (or in this case moving averages) aren’t a measure of future performance as much as they are about prevailing sentiment among buyers and sellers. Moving averages measure the momentum of an asset. When a stock is trading above its moving average it is drawing attention from more buyers than sellers. Conversely, when a stock is trading below its moving average, it is drawing attention from more sellers than buyers.
However, as with many things regarding investing, moving averages come in many varieties. In many cases, investors like to look at a combination of moving averages that work in tandem to more closely identify patterns. One of the key indicators that investors use to identify buy and sell signals is the moving average convergence divergence (MACD) oscillator. In this article, we’ll break down the MACD while giving an overview of moving averages and the terms you need to know to understand this indicator and how it can be used as part of a successful trading strategy.
What is the moving average convergence divergence (MACD) oscillator?
The moving average convergence divergence (MACD) oscillator is a technical analysis tool that is an indicator of momentum that provides traders with a visual indicator of buying and selling trends. The MACD is then calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA:
MACD = 26-period EMA – 12 period EMA.
The difference between these two EMAs is what is shown on a stock chart as the MACD line. A MACD chart can be expressed as a daily chart, monthly chart or for whatever time period is helpful for a particular trader.
The other essential component of the MACD is the signal line. The signal line is the 9-day exponential moving average of the MACD. On a stock chart, the signal line is plotted above the MACD line.
The signal line is what traders call a "trigger". When the price of an asset crosses over the signal line, it can be a buy or sell signal. For example, when the MACD crosses above the signal line that is usually bullish or buy signal that suggests demand for the asset is increasing. When the MACD crosses below the signal line that is a bearish signal that suggests demand for the asset is decreasing.
The MACD is considered an oscillator because the MACD line and signal line oscillate above and below a zero line (also called a baseline). Before we get into detail about the significance and potential meaning of crossovers, divergences, and rapid rise/falls that the MACD reveals, let’s take a moment to review some terms and concepts.
Key terms to help explain MACD
Moving average– a moving average shows the relationship between an asset’s current price and the average of its closing price over a period of time. So a 10-day moving average will show the average closing price of an asset for the prior 10 trading days. Moving averages can be measured over virtually any time period that a trader wants to use. Day traders and other high volume traders may look for moving averages that measure a shorter period of time such as an hourly moving average. However, two of the most frequently cited moving averages are the 20-day moving average (short-term) and the 200-day moving average (long-term). Like the MACD when an asset rises above its moving average, particularly a long-term moving average, it is a buy signal. The opposite is true when an asset falls below its moving average. Moving averages can be used by themselves or used alongside other technical indicators. The two most commonly used moving averages are the simple moving average (SMA) and the exponential moving average (EMA).
Simple moving average– A simple moving average (SMA) adds the closing price for an asset for a period of time and divided it by that time period. So for a 10-day moving average, an investor would look at the previous 10 trading days, add the closing prices together and divide that number by 10.
Example: Stock ABC has the following closing prices for the last 10 trading days:
11.51, 11.73, 12.43, 12.12, 11.98, 11.67, 11.78, 12.01, 11.90, 11.78
It’s 10-day SMA is calculated as:
SMA = (11.51 + 11.73 + 12.43 +12.12 + 11.98 + 11.67 + 11.78 + 12.01 + 11.90 + 11.78)/10
SMA = 118.91/10 = 11.89
This means the average closing price for stock ABC over the last 10 trading days was 11.89.
Exponential moving average– An exponential moving average is a weighted moving average that assigns more significance to the most recent data points in a moving average. Most trading platforms will calculate an asset’s EMA or SMA for you. For that reason, we’ll leave the specifics of the EMA calculation for a different article. What’s important to understand about the EMA as it relates to MACD is that the EMA will react more significantly to recent price changes when compared to the SMA.
Histogram– a chart that shows the frequency distribution of a variable. In the case of MACD, a histogram shows bullish or bearish momentum based on the MACD line’s relationship to its signal line.
Convergence – a trading indicator that is evidenced by the two moving averages moving towards each other.
Divergence– a trading indicator that is evidenced by the two moving averages moving away from each other.
How to interpret MACD
Interpreting MACD requires looking for the areas of convergence and divergence between the two moving averages. The shorter period moving average is known as the faster indicator because it is more reactive to price changes. The longer period moving average is known as the slow indicator, meaning it is less sensitive to price changes. Think of it as a batter in baseball. Early in the season, their batting average can change significantly from one at-bat to the next because it doesn't take much to move their average. However, later in the season, the player's batting average is much less sensitive to the results of any one at-bat.
The MACD can be considered positive or negative depending on the relationship between the two underlying EMA values. When the 12-day EMA (short term) is greater than the 26-day EMA (long term) the MACD has a positive value. When the opposite is true, the MACD has a negative value. As the distance above or below the MACD and the zero line increases, the distance between the two EMAs will also be growing. To help visualize this, many MACD charts will display a histogram that shows the distance between the MACD line and the signal line. When the MACD line is above the signal line, the histogram will be above the zero line. When the MACD line is below the signal line, the histogram will be below the zero line. On many charts, the colors of the histogram may be green (for a positive value) or red (for a negative value).
When trading the MACD, all of this information comes together in three signals.
- Signal line crossover patterns – Signal line crossover is the point where the MACD line and the signal line cross each other. When the MACD line crosses below the signal line, it is considered a bearish indicator. When the MACD line crosses above the signal line, it is considered a bullish indicator. However, a single crossover does not indicate a trend. For example, a stock that is in the midst of a correction may have a brief rally, but then continue down. Traders will look for a confirmation signal. A bullish confirmation would be having the MACD line cross above its signal line, then briefly fall below it, before crossing above it. This reflects the "higher highs" and "higher lows" that are typical of an uptrend. Similarly, a bearish confirmation would be when the MACD line crosses below its signal line than briefly jumps above only to fall below it again. Crossover patterns can confirm levels of support and resistance.
- Centerline crossover patterns – Center line crossover patterns are similar to signal line crossover patterns except that they involve only the MACD line and its relationship to the center line or zero line. As stated above when the MACD line rises above the zero line it is considered a bullish signal. When the MACD line drops below the zero line, it is considered a bearish signal.
- MACD divergence patterns – Divergence occurs when the MACD line forms a rising low when the price is showing a falling low (a bullish divergence) or when the MACD is showing a falling high when the price is showing a rising high (a bearish divergence). This is a different divergence than when the MACD line moves further away from the signal line.
- Rapid rises or falls – This is a situation that occurs when the underlying short term moving average (the 12-day) moves rapidly away from the long term moving average (26-day). This will cause the MACD line to rise or fall rapidly. Evidence of a rapid rise or fall can indicate an overbought or oversold condition. However, since the MACD is a lagging indicator (meaning it is displaying price movement that has already taken place), traders will typically use other technical indicators such as the Relative Strength Index (RSI) to verify if the overbought or oversold conditions truly exist.
The final word on MACD
The MACD oscillator is one of the most used tools in technical analysis. The MACD is unique in its ability to simultaneously show traders price momentum and price trend. The MACD shows the relationship between two exponential moving averages. One moving average will be a short term EMA and the other will be a long term EMA. The typical settings are a 12-day EMA for the short term and a 26-day EMA for the long term. These can be adjusted based on the sensitivity that traders are looking for. To get the proper trading signals, traders will pay attention to the MACD line as well as the signal line which is a 9-day EMA for the asset and the zero line or baseline. Three of the buy and sell signals that traders look for occur when the MACD line crosses over the signal line (a signal line crossover), when the MACD line crosses over the center line (a center line crossover), or when the MACD line and signal line move further apart in price (divergence). Finally, although by itself, the MACD is not the best representation of oversold or overbought conditions, the presence of rapid rises or falls in the MACD when compared with other technical indicators such as the Relative Strength Indicator (RSI) can be used to accurately confirm whether an overbought or oversold market.