MACD INDICATOR EXPLAINED – MOVING AVERAGE CONVERGENCE/DIVERGENCE EXAMPLES
Definition & Explanation:
The moving average convergence-divergence indicator – better known as MACD (pronounced “mac-dee”) – is one of the most popular tools in all of technical analysis and has been used since the late 1970s. MACD is part of the oscillator family of technical indicators.
It was developed to measure the characteristics of a trend. These include its direction, magnitude and rate of change. It can therefore be used for both its trend following and price reversal characteristics
The MACD consists of two different lines and visually appears as follows (bottom chart):
It is calculated from three different factors:
- The MACD SMA: This is the difference between a “long” exponential moving average (EMA) and a “fast” EMA
- The “average” or “signal” series is the EMA of the MACD series described above (Slow EMA)
- The “Divergence” series is the difference between the MACD series and the average series (Fast EMA).
MEANING OF THE MOVING AVERAGE CONVERGENCE-DIVERGENCE
The MACD derives its name from the moving averages it is based on and how they behave
Convergence refers to the meeting of the two moving averages. This could be interpreted as confirmation that a trend reversal is underway.
Divergence can have two meanings. It can mean that two moving averages are moving apart or that the trend in the security could be strengthening.
Divergence could also refer to a discrepancy between the price and the MACD line, which some traders may attach importance to
If the price reaches a high while the MACD line is declining (referred to as “negative divergence” or “bearish divergence”), this could indicate that the price could be falling. If the price reaches a new low while the MACD line is rising (referred to as a “positive divergence” or “bullish divergence”), this could indicate that the price might be rising.
Settings of the MACD
MACD is generally set up with the notation form MACD(a,b,c). The letter variables denote time periods
The a and b variables refer to the time periods used to calculate the MACD series mentioned in Part 1 above. These are subtracted from each other (i.e., short EMA minus long EMA)
This represents one of the two lines of the MACD indicator and is indicated by the white line below it. (Of course, the line colors vary depending on the charting software, but are almost always adjustable)
Variable c represents the period of the EMA taken from the MACD series above. This represents the orange line below added to the white MACD line
MACD parameters a, b and c are generally set to MACD(12,26,9). These will be the default settings in almost all charting software platforms as traditionally applied to the daily chart
In an earlier era, the trading week was six days instead of five.
Therefore, the logic behind these settings was that the 12-period (“fast”) EMA would track the trend of the last two weeks. The 26-period (“slow”) EMA would track the trend of the past month. And the 9-period EMA of the difference between the two would track the trend of the last week and a half
Traders are always free to adjust them as they see fit. However, since so many other traders track MACD through these settings – and especially on the daily chart, which is by far the most popular time compression – it might make sense to leave them as they are
Part of the reason why technical analysis can be a profitable trading method is because other traders follow the same cues provided by these indicators. Price often moves accordingly based on these indicators.
Deviations from the MACD(12,26,9) setup
The default MACD(12,26,9) setup is useful in that it is used by everyone else for the most part. But varying these setups to see how the trend moves in other contexts or over other time periods can certainly be useful as well
For example, traders may consider using the MACD(5,42,5) setting. When used on the daily chart, this sets the fast EMA to one week’s worth of data, the slow EMA to two months’ worth of data, and the MACD series EMA (signal line) to five periods
The shorter the EMA of the MACD series, the closer it will be to the MACD series. When the EMA of the MACD series is set to one period, it is exactly the same as the MACD series, as shown below
Basic mechanics (strategy) and interpretation of MACD
When the price is in an uptrend, the white line will be positively sloped. The 12-period EMA reacts faster to a price increase than the 26-period EMA, resulting in a positive difference between the two
The orange line (signal line) – the 9-period EMA of the white line (MACD line) – will follow the trend of the white line. The way the EMAs are weighted will favor the latest data. When the EMA-9 crosses above the MACD(12,26), it is considered a bearish signal. It means that the trend in the stock – its size and/or momentum – is starting to change course. When the MACD(12,26) crosses above the EMA-9, it is considered a bullish signal
Below are examples marked by arrows in each case:
It is also common to display the MACD as a histogram (bar chart instead of a line) for better visualization. Charting software usually gives you the option to change the color of the positive and negative values for additional ease of use
Since the crossover of MACD(12,26) and EMA-9 is the most important trading signal, many prefer the histogram
However, it should be noted that if you only use the histogram, you will not be able to tell if the MACD line is positive or negative, or if the trend is interpreted as up or down. The histogram interprets whether the trend is becoming more positive or negative, not whether it may be changing itself.
How is the MACD useful?
The MACD is based on moving averages. Since moving averages accumulate past price data according to setting specifications, it is inherently a lagging indicator. It is simply designed to track trend or momentum changes in a stock or other market such as Forex that may not be easily captured by looking at price alone
The indicator is most useful for stocks, commodities, indices and other forms of securities that are liquid and trending. It is less useful for instruments that trade irregularly or are tied to specific ranges.
More comprehensive interpretation
MACD revolves around the use of exponential moving averages of varying lengths (sometimes referred to as “speeds” – fast (short) versus slow (long)). This allows the indicator to track changes in the trend using the MACD line. The signal line tracks changes in the MACD line itself
For those who may have studied calculus in the past, the MACD line is similar to the first derivative of price with respect to time. The signal line is similar to the second derivative of price with respect to time or the first derivative of the MACD line with respect to time
The crossover – often referred to as a “signal line crossover” – occurs when the MACD line crosses the signal line. Many traders consider these to be bullish or bearish trading signals in and of themselves. A crossover can be interpreted as a case where the trend of the security or index accelerates
When the MACD line crosses the average line upwards, it is considered a bullish signal. If the MACD line crosses downward above the average line, this is considered a bearish signal. This can be easily tracked by looking at the MACD histogram. A bullish signal occurs when the histogram changes from negative to positive. A bearish signal occurs when the histogram changes from positive to negative
Zero line crossing
A crossing of the zero line occurs when the MACD series moves across the zero line or the horizontal axis. That is, when it moves from positive to negative or from negative to positive. This means that the two EMAs that make up the MACD series are exactly the same
When the MACD series moves from positive to negative, it can be interpreted as a bearish signal. If it runs from negative to positive, this could be interpreted as a bullish signal
While zero crossings can indicate a change in the direction of a trend, traders generally place more emphasis on a signal line crossing, as a zero crossing in and of itself provides no indication of the rate of change of the trend
Analogy to moving cars
You can think of the MACD in terms of the basic physics of a moving car
If a car is moving forward (positive velocity) and accelerating (increasing velocity), it means it is getting from point A to point B faster. This analogy can be applied to price when the MACD line is positive and above the signal line. This is a bullish sign
When the car hits the brakes, its speed decreases. This could mean that its direction is starting to change, although the speed is still positive. This would correspond to a signal line crossing, but the MACD line is still positive. Some traders may be bearish on the trend at this point
When a car is moving in reverse (negative speed) and accelerating in the opposite direction (speed decreases or becomes more negative), it means that it is moving faster away from its previous location. This corresponds to the price interpretation of the MACD when the MACD line is negative (negative speed) and the signal line is above the MACD line (negative acceleration). This is a bearish sign.
Now, if the car is going backwards (velocity still negative) but hits the brakes (velocity becomes less negative or positive acceleration), this could be interpreted by some traders as a bullish signal, meaning that the direction is about to change.
Some traders only pay attention to the acceleration – i.e. the signal line crossing (or what is expressed by the MACD histogram). They believe that the trend change is the most important and use it as a price reversal indicator rather than its trend following component (regardless of whether the MACD line is positive or negative – “speed”)
Some traders, on the other hand, take a trade only when both velocity and acceleration are in sync. Namely, the MACD line must be both positive and cross above the signal line in order to have a bullish signal. Or the MACD line must be negative as well as cross below the signal line to get a bearish signal.
As mentioned earlier, the MACD line is very similar to the first derivative of price with respect to time. The velocity analogy applies provided that velocity is the first derivative of distance with respect to time.
The signal line is very similar to the second derivative of price with respect to time or the first derivative of the MACD line with respect to time. Moreover, the analogy of acceleration works in this context because acceleration is the second derivative of distance with respect to time or the first derivative of velocity with respect to time.
The importance of filtering the right trading signals
The MACD is not a magic solution to determine where the financial markets are headed in the future. Taking MACD signals on their own is a risky strategy. Filtering signals with other indicators and analysis modes is important to filter out false signals.
In terms of MACD, this is called a “false positive” when a bullish crossover (i.e., a MACD line crosses above the signal line) occurs but the price of the security declines. When a bearish crossover occurs (i.e. MACD line crosses below the signal line), but the price of the security increases, this is called a “false negative”
False signals can be avoided by avoiding them in markets with narrow ranges. Below, in the left half of the chart, we see several signals from flat crossings that do not give well-defined signals
As with all technical indicators, taking signals from just one is unlikely to sway the odds in your favor over a long enough period of time
The confluence of multiple factors working in your favor – e.g. alignment of 2-3 indicators, candlestick patterns, support/resistance, fundamental analysis – will increase the likelihood that a particular trade will work.
Suitable platform and broker for MACD trading
Nowadays, almost every trading platform offers MACD as an indicator. The most popular software in the world is MetaTrader 4/5, which is free to use and you get the market data from a broker. You can set your charts and indicators according to your preferences with this software
Examples and strategies for trading with MACD:
If trades are made based on crossings of MACD lines and signal line, it means that you are always in the market. If you don’t filter it more strictly, you will always be in either a buy/long trade or sell/short trade and will oscillate between the two
Consider the following daily chart of EUR/USD where the buy/long signal is a MACD series crossover above the signal line and the sell/short signal is a MACD series crossover below the signal line. Of course, if another crossover occurs, it means that the previous trade is taken off the table
Here I have captured about five months of price data. Although the standard signal line crossover strategy from the MACD(12,26,9) settings would have made a small profit overall, this strategy is too naive to make an entire system out of
Instead, we should consider adding to the indicator to make it at least a little more robust. In this case, we add a simple 50-period moving average (SMA). Of course, this is still very basic, but this is simply an example of what can be done to improve the odds by using MACD along with another indicator
We will make this a system with three rules for entries and exits:
- The entry is made via a signal line crossing. A MACD series above the signal line is a bullish signal. MACD series below the signal line is a bearish signal
- Enter trades only in the direction of the close as dictated by a 50 period SMA
- Exit the trade when another signal line crosses or the slope of the 50-period SMA changes
As mentioned earlier, the system can be further refined to improve its accuracy. This may include the inclusion of other indicators, analysis of candlestick and chart patterns, support and resistance levels, and fundamental analysis of the traded market. When including other indicators, it is best not to overdo it. If you wait for six indicators to align perfectly, you will probably end up with a very messy and confusing chart. You never want to end up with information overload. To trade well, it is necessary to be conservative about the trades you make and to be patient in letting them come to you. But if you are too conservative, you will never quite get to trade. The key is to find the right balance using the tools and analysis methods mentioned above.
Conclusion about MACD Trading
MACD is one of the most popular indicators used by technical analysts. It helps to identify the direction of the trend, its speed and its rate of change. A MACD crossover of the signal line can help identify when the acceleration of the trend is changing. A MACD crossover of the zero line can be interpreted as the trend direction changing completely.
In an accelerating uptrend, the MACD line is expected to be both positive and above the signal line. In an accelerating downtrend, the MACD line is expected to be both negative and below the signal line
Some traders will focus solely on the acceleration component of the MACD (signal line crossing of the MACD line). However, some traders will choose to have both in line
MACD is a versatile indicator and can be used as part of a trader’s toolkit to confirm trends and potential price reversals