What is Moving Average Convergence Divergence (MACD)?

Moving Average Convergence Divergence (MACD or MAC-D) looks at the relationship between two exponential moving averages (EMA) of an asset and compares it to another EMA called the signal line. The movement of the MACD line above and below the signal line is then used to determine potential trading strategies.

Like with EMA, we use the closing prices of the asset.

How do you calculate Moving Average Convergence Divergence (MACD)?

The most common MACD indicator calculation = (12-day EMA - 26-day EMA) and then this MACD line is plotted against a separate 9-day EMA to create the MACD histogram (in the next section I’ll show you how to interpret the MACD histogram).

If you need a refresher on the exponential moving average formula, click here. The EMA is a type of moving average that places greater weight on more recent data points.

How do you interpret MACD?

In the image below, you can see an example stock price ticker (on the top). The MACD line is the red line below and the signal line is the blue line. As the MACD line is calculated by subtracting the 26-day EMA from the 12-day EMA. If 12-day EMA > 26-day EMA, the MACD line will be above 0 and if the 26-day EMA > 12-day EMA, then the MACD line will be below 0. The greater the movement away from 0, the greater the divergence between the two EMAs.

The MACD line (red) is then compared to the signal line (blue, 9-day EMA) and this creates the MACD histogram (the lower histogram bar chart). If the MACD line is above the signal line, the histogram will be above the zero line and if the MACD line is below the signal line, the histogram will be below the zero line.

When the MACD line rises above the signal line, this could indicate a bullish signal. When the MACD line falls below the signal line, this could indicate a bearish signal.

The example image above shows an MACD divergence: The price of the asset is falling to a new low while the MACD is moving in the opposite direction indicating a bullish signal.

How can you use Moving Average Convergence Divergence (MACD) in a stock trading strategy?

MACD is used in technical analysis in a variety of ways.

MACD crossovers

One popular strategy is MACD signal line crossovers (or MACD crossover). When MACD line crosses above the signal line, this can indicate a bullish signal and hence MACD can be used as a momentum indicator suggesting that there may be upward price action (bullish crossover). Conversely, when the MACD line crosses below the signal line, this can indicate a bearish signal and it could indicate downward price action (bearish crossover).

If there a brief short-term switch in direction compared to the overall trend (e.g. MACD line briefly crosses above signal line following a long downtrend), this can help confirm the signal - in this case, a bearish signal.

MACD divergence

What is MACD divergence in simple terms? Any divergence is when the price of the asset moves in a different direction to the oscillator (MACD histogram in this case). For example, if the price moves to a new low but the MACD histogram is moving in the opposite direction (or at least doesn’t reach a new low of it’s own), then this is called a bullish divergence and it can indicate a buy signal.

On the other hand, if there are price movements to a new high, but the MACD histogram is moving in the opposite direction, then this could indicate bearish divergence and a sell signal.

As a result, traders can use this an indicator of potential price reversals.

MACD rapid rises or falls

Rapid rises or rapid falls MACD can be used to understand if an asset has been overbought or oversold, similar to Relative Strength Index (RSI). For example, if MACD rises rapidly (the short term EMA is pulling away from the longer term EMA and this in turn moving away from the signal line), then this can indicate that an asset has been overbought.

What’s the difference between RSI and MACD? While RSI has ranges of values that can indicate if an asset has been overbought or oversold (e.g. >70 for overbought), MACD doesn’t have the same and should be compared on a relative basis with the price of the asset and the signal line.

What are the limitations of Moving Average Convergence Divergence (MACD)?

MACD uses historical data and as the saying goes, past performance is not an indicator of future performance (MACD is a lagging indicator). If you believe that markets are efficient, then the current market price already reflects all available information and hence MACD doesn’t tell you anything more.

Another limitation of MACD divergence is that it can indicate a false positive or false signal (i.e. it indicates a trend reversal but that doesn’t happen). As a result, traders can use Average Directional Index ADX as a confirmation signal alongside MACD.

In addition, MACD uses EMA which weights the most recent data more and there is debate on whether this can cause bias.

What are similar indicators to Exponential Moving Average (EMA)?

Other technical indicators related to MACD include the moving averages that make up the MACD line:

• Simple Moving Average (SMA) - A moving average indicator that places equal weight on all prior time periods.

• Exponential Moving Average (EMA) - While SMA places an equal weight on all time periods, the EMA places more weight on more recent time periods. The EMA is an example of a weighted moving average.

• Relative Strength Index (RSI) - RSI is another commonly used momentum indicator.

Sources

• https://www.investopedia.com/terms/m/macd.asp#toc-what-is-moving-average-convergencedivergence-macd

• https://www.investopedia.com/terms/e/ema.asp

• https://www.investopedia.com/terms/s/sma.asp

• https://www.asktraders.com/gb/learn-to-trade/trading-strategies/macd/

• https://en.m.wikipedia.org/wiki/MACD