MACD, which stands for Moving Average Convergence Divergence, is a tool created to assist investors in spotting price trends, gauging the strength of those trends, and pinpointing moments of acceleration for better timing when entering the market, be it for buying or selling. This indicator was crafted in the late 1970s by technical analyst Gerald Appel.
Appel, the creator of MACD, held the belief that accurately gauging the momentum behind well-defined trends is crucial for success in trading. However, the challenge lies in the fact that the ups and downs of prices and the overall volatility of the market can sometimes obscure the true trend. Identifying market trends, much like recognizing economic cycles, is often easier in hindsight than in real-time.
To tackle this issue, Appel designed the MACD indicator. Its purpose is to not only clearly identify trends but also measure the momentum propelling those trends and generate signals for trading based on moments of trend acceleration. Appel described it as “an indicator for all seasons,” emphasizing its adaptability to various market conditions.
How MACD works
The MACD indicator may seem complex, but it boils down to three key components:
- MACD Line: This represents the difference between two moving averages.
- Signal Line: It’s a moving average of the MACD line.
- Histogram: This is another element that provides a visual representation of the difference between the MACD line and the Signal line.
MACD takes the idea of moving averages a step further. While comparing a fast and a slow moving average is a good start, MACD goes beyond that.
Firstly, the MACD line is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA (fast minus slow). Why? This calculation is designed to highlight the relationship between the two averages, placing more emphasis on recent price data.
Now, the signal line steps in. It’s a 9-day EMA of the MACD line. In simpler terms, it’s a moving average of the difference between two moving averages, or a slower version of the difference between a fast and a slow moving average.
Why bother with a moving average of two other moving averages? The signal line smooths out the MACD line, creating an even slower moving average that acts as the counterpart to the faster MACD line.
What about the histogram?
The histogram is like a visual guide, split into two parts by a baseline or zero line. It helps us see when the MACD line is above or below the signal line. Additionally, the size of the bars in the histogram indicates how much the MACD line is above or below the signal line. Think of it as a handy visual reference.
How to Use the MACD in Trading
Keep a close eye on the moving averages – both the MACD and the signal line – and how they relate to the histogram.
Here’s a simple guide: When the MACD line (the faster moving average) is above the signal line, and the bars in the histogram are above the zero line, it’s considered a bullish signal.
Conversely, when the MACD line is below the signal line, and the histogram bars are below the zero line, it tends to be bearish.
Many traders see bullish crossovers (like in figure 2) as buy signals and negative crossovers as sell (or sell short) signals. However, interpreting crossovers is a personal choice. Using the MACD, like many technical indicators, involves a mix of art and science.
Try it out first to see how it fits into your buying and selling strategy.
Momentum traders using the MACD indicator pay attention to specific cues, focusing on these five:
- MACD Crossing the Zero Line: When the MACD line moves from below to above the zero line on the histogram, it’s considered bullish. Conversely, if the MACD line crosses from above to below the zero line, it’s seen as bearish.
- MACD Crossing the Signal Line: A bullish sign is when the MACD line crosses from below to above the signal line, and a bearish sign is when it crosses from above to below the signal line.
- Distance of Crossings from the Zero Line: Bullish MACD/signal line crossings may be more reliable when they occur further below the zero line. On the other hand, bearish crossings may be more reliable when they happen further above the zero line.
- Trading Ranges and Whipsaws: In times of weak trends and price fluctuation between support and resistance levels, frequent back-and-forth crossings of the MACD line and signal line might occur. Traders may avoid taking positions during such periods to prevent being “whipsawed” in a sideways or non-trending market.
- Divergences in Signals: When prices trend in one direction while the MACD indicator trends in the opposite direction, it’s called a “divergence.” MACD/signal line crossovers accompanied by divergences tend to provide more reliable signals than those without divergences.
Pros and Cons of Using MACD:
Pros:
- Trend Identification and Momentum Measurement: MACD helps identify trend direction, measure momentum, and pinpoint entry points for buying or selling assets.
- Reliability Anticipation: The distance between crossovers and the histogram’s zero line allows traders to gauge the reliability of buy and sell signals.
- Versatility: MACD is adaptable to different chart time frames, making it suitable for both short-term and long-term trades.
Cons:
- Lagging Nature: The primary downside is that MACD can sometimes lag due to its reliance on moving averages (past data). Past performance does not guarantee future results, and in rapidly changing markets, MACD signals may be delayed.
- Performance in Non-Trending Markets: MACD is a trend-following indicator, so it doesn’t perform well in non-trending markets or when prices move within a range. This can lead to false signals, particularly when prices are stuck between support and resistance levels. Predicting when prices will become range-bound can be challenging.