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Moving Average Convergence/Divergence: Definition, Origin          

Moving Average Convergence/Divergence: Definition, Origin, How it Works, Formula, and Calculations

Moving Average Convergence/Divergence: Definition, Origin, How it Works, Formula, and Calculations

Moving average convergence/divergence is a trend-following momentum indicator that shows the relationship between two exponential moving averages (EMAs) of a security’s price. Moving average convergence/divergence( MACD) is one of the most popular momentum indicators used in technical analysis.

Gerald Appel created MACD at the end of the 1970s. Appel is legendary for his work in technical analysis and market timing, including the creation of Moving Average Convergence-Divergence(MACD), one of the field’s most widely used tools.

The MACD indicator is calculated by subtracting the longer-term exponential average from the shorter-term exponential average. The level at which the short and longer-term moving averages cross, where they are equal, is the 0 line on the chart.

The MACD line is calculated by subtracting the 26-period EMA from the 12-period EMA.

What is Moving Average Convergence/Divergence?

The Moving Average Convergence Divergence(MACD) indicator is utilized to comprehend momentum and its directional strength, by measuring the difference between two time periods that constitute a collection of historical time series. MACD represents the difference of the short-term exponential moving average minus the long-term exponential average.

Short-term averages increase more quickly than long-term averages when market trends are improving, MACD lines will turn up.

Shorter-term averages have a tendency to flatten when market trends are declining, and they will eventually fall below longer-term averages if the decline continues, MACD lines will converge to zero.

In the course of price movements, short-term moving averages move apart (diverge) and move together (converge) with longer-term moving averages, hence the indicator name moving average convergence divergence.

MACD indicator measures the difference between two exponential moving averages and plots the difference as a line chart. The difference between the MACD line and a second signal line is then drawn as an easy-to-interpret histogram. There are two major ways to read a MACD indicator. First, to analyze whether the market is overbought or oversold, and second, to interpret a downward and upward trend in the market.

The MACD is a momentum oscillator primarily used to trade trends. MACD signals prove to be reliable if shorter-term MACD signals are confirmed by longer-term trends in the stock market, reflected by longer-term MACD patterns. Purchases done based on daily MACD lines have more chances to succeed if weekly or monthly MACD patterns are favorable, indicating strength in the primary market cycle. Short-term short sales are more profitable if longer-term market trends are down.

The signal line is the exponential average of the MACD levels. Three- to nine-day MACD exponential averages are used typically to construct signal lines. 

Buy signals are more reliable, when the MACD has crossed from above to below 0 at some point since the most recent sell signal. The MACD is not required to be below 0 at the time of the buy signal, but it should have been below 0 at some time since the start of the recent decline.

Sell signals are more reliable when the MACD has crossed from below to above 0 at some time since the most recent buy signal. The MACD does not have to be above 0 at the time of the sell signal, but it should have been above 0 at some time since the start of the most recent advance. 

What is the Origin of MACD?

MACD was proposed by Gerald Appel in the late 1970s. It evolved from the exponential moving average (EMA). 

MACD is a common indicator in stock analysis. It is a featured indicator on virtually every computer-based technical trading program and trading platform. 

The MACD histogram, which was developed by T. Aspray in 1986, measures the signed distance between the MACD and its signal line calculated using the 9-day EMA of the MACD.

How does the MACD indicator work?

The MACD indicator works with 3 components, namely the MACD line, the signal line and the histogram.

The main MACD line is the difference between the longer moving average (26-period) from the shorter one (12-period). The MACD line helps determine upward or downward momentum, i.e., market trend.

The signal line is the Exponential Moving Average (EMA) ( 9-period typically) of the MACD itself. The MACD gives a buy signal when it moves above its own nine-day EMA and sends a sell signal when it moves below its nine-day EMA. 

The histogram is the graphical representation of the convergence and divergence of the MACD line and the signal line, that is the distance between the two of them. A positive histogram value indicates that the MACD is above its 9-day moving average and indicates a recent shift in momentum in the positive direction. A negative value, on the other hand, indicates a recent downward movement in momentum.

A buying opportunity for the trader occurs if the MACD line remains above the signal line at a time when stock prices are rising. It indicates a selling opportunity when the MACD line remains below the signal line at a time when stock prices are falling.

What is the Formula for MACD indicator?

MACD is calculated by subtracting the long-term EMA (26 periods) from the short-term EMA (12 periods).

MACD=12-Period EMA − 26-Period EMA

Where,

MACD= Moving average convergence divergence

EMA=   Exponential Moving Averages

An EMA is a kind of moving average (MA) that gives the most recent data points more importance and weight.

How to Calculate the MACD indicator?

Several calculations are required to create the overall indicator (MACD), all of which involve the use of exponential moving averages.

To determine a 12-period EMA, calculate the sum of the previous 12 periods divided by 12.

[Weight Multiplier = K = 2/(n+1) where n = period ]

Calculate the weighting multiplier using this equation:

2/12+1 = 0.1538

Calculate the 12 EMA sequentially as:

(Close – EMA previous period) ∗0.1538+EMAprevious period

Calculating the MACD requires  doing all of the following EMA calculations for any given market instrument :

  • Do a 12-period EMA calculation for the price over the selected time frame.
  • Perform a 26-period EMA calculation for the price over the selected time frame.
  • The MACD line is produced by subtracting the 26-period EMA from the 12-period EMA.
  • Create the signal line by calculating a nine-period EMA of the MACD line (the outcome of step 3).
  • To produce the histogram, subtract the signal line from the MACD line.

Positive and negative values are shown by a zero line on the MACD. The MACD is positive when the 12-period EMA is higher than the 26-period EMA; conversely, it is negative when the 12-period EMA is lower than the 26-period EMA.

How to use the MACD indicator in Technical Analysis?

There are 3 trading strategies that use MACD technical indicators namely crossovers, MACD zero cross strategy and MACD histogram.

Crossovers:- A crossover appears when the signal line and the MACD line cross each other. A bullish signal is produced when the MACD crosses over its own nine-day EMA, and a bearish signal is produced when it crosses below it.

MACD Zero-Cross Strategy:- The zero-cross approach is based on the zero line being crossed by any EMAs. A new uptrend forms when the MACD crosses the zero line from below, while a new downtrend forms when the MACD crosses from above. This method should be used carefully in quick, choppy markets due to the delayed nature of the signals. This method, however, can be highly useful for sending reversal indications for significant sweeping advances. 

MACD Histogram:- The most useful aspect of MACD is the histogram, where the bars represent the difference between the MACD and signal lines.

The histogram will rise in height when the market price is moving quickly in one direction and it will decrease when the market is moving slowly. The two moving average lines are moving wider apart as the bars on the histogram travel further away from zero. 

A humped shape develops once the first expansion period ends; this indicates that the moving averages are once again tightening, which can be an indication of a crossing.

How to use MACD Indicator in Stock Market Trading?

The different signals provided by the MACD indicator are used by traders in the stock market to forecast trends, momentum, and changes in stock prices. These signals are the MACD hook, the hidden divergence, and the histogram squeeze.

  1. The MACD Hook:- The hook occurs when the signal line and the MACD line cross each other without touching.

The MACD hook mainly identifies moves that are against trend in trending markets. The hook proves helpful for traders to buy pullbacks during an uptrend and sell them during a downtrend. It also helps traders identify potential trade setups.

  1. The hidden divergence:- Divergence occurs when the stock price moves in one way (either up or down) and the indicator moves in a different direction at the same time. Hidden divergence is the exact opposite of divergence and is referred to in the context of bullish and bearish divergence formations.

A bullish divergence occurs when the current price low exceeds the previous swing low and the MACD line forms an opposite pattern.

The Bearish divergence is just opposite of the bullish divergence. It occurs when the price or rate begins to move in a downtrend, forming both higher highs and lower highs, with the MACD forming an opposite pattern.

  1. The histogram squeeze:- The price range becomes small and narrow when volatility in the market is low, and the chances of explosive breakouts are high. The MACD histogram helps the trader to recognize that an explosive breakout is about to happen.

To determine this type of breakout, you first need to check if the price comes into a small range. At the same time, the MACD histogram looks flat. You can enter the trade when the price breaks the small range and the histogram expands at the same time.

When is the best time to invest using MACD?

MACD is best used with daily periods, where traditional settings of 26/12/9 days is the norm. The 12 represents a moving average of the previous 12 bars. The 26 represents a moving average of the previous 26 bars.

The 9 represents a moving average of the difference between those two moving averages.

How to read a MACD indicator chart?

There are 3 components which make up the MACD indicator chart. These indicators are the MACD line, the signal line, and the MACD histogram.

1.)MACD Line –  It is the fastest moving average (short-term EMA)

2.)Signal line –  It is the slowest moving average(long-term EMA)

3.)MACD Histogram –  It swings above and below a zero line, allowing bullish and bearish momentum readings to be distinguished.

A potential buy signal is formed when the long-term EMA crosses above the short-term EMA, and a potential sell signal is formed when the short-term EMA crosses below the long-term EMA.

What are the benefits of a MACD indicator?

MACD is a popular tool in technical analysis because it has major benefits as compared to other tools. 4 of these benefits are listed below:-

  • The MACD indicator is the most often used technical analysis tool because it enables traders to rapidly and easily determine the direction of the short-term trend.
  • The clear transaction signals help minimize the subjectivity involved in trading, and the crosses over the signal line make it easy for traders to ensure that they are trading in the direction of momentum.
  • It is a straightforward trading indicator that can generate sufficient indications. The MACD provides indicators of the strength of the trend.
  • One of the key benefits of the MACD indicator over some of the other technical analysis indicators is its capacity to spot trend reversals; since trades may indicate suitable entry and exit points. In contrast to moving average indicators, it gives current information.

We can, hereby infer that MACD enables traders to spot trend reversals and provides clear transactional signals to minimize subjectivity.

What are the limitations of MACD indicator?

The MACD indicator does not only have advantages, it has these 5 limitations as well.

  •  It is not recommended to use a MACD indicator if you are a long-term trader, because it is considered a short-term indicator, for the reason that the longest period it incorporates is the 26-day exponential moving average.
  • You must determine the ideal MACD setup for various assets or markets. The MACD divergence produces early signals, which leads to some poor positions before joining a profitable one.
  • As a lagging indicator, when it signals a potential trade you have usually missed some of the profits because you will enter the position later.
  • One of the most significant risks is that a reversal signal can be a false indicator.
  • MACD struggles to work effectively in sideways markets. When prices are in a range between support and resistance, they tend to shift to the side. Because there is no upward or downward trend, where the moving average performs best, MACD tends to drift towards the zero line.

In conclusion, A trader should not completely rely on MACD indicator for long-term trading and also look out for false reversal signals.

What are examples of MACD indicator?

The MACD indicator can be understood by taking the given chart as an example.

In the above chart, the yellow area implies that the MACD line is in negative territory when the 12-day EMA is below the 26-day EMA. After the initial cross (black arrow), the MACD moved further into negative territory as the 12-day EMA diverged further from the 26-day EMA. 

Negative values increase as the shorter EMA diverges further below the longer EMA. This means downside momentum is increasing.

The orange area highlights a period of positive MACD readings, i.e. when the 12-day EMA was above the 26-day EMA. Positive values increase when the shorter EMA deviates further from the longer EMA. This means that the upward momentum increases. 

What to know more about using MACD in Trading?

MACD indicator has a variation known as MACD percentage price oscillator. Signal line crossovers are almost identical. The major difference is the MACD Percentage scale which enables comparison between stocks at different prices.

MACD Percentage Price Oscillator’s trading signals are the same as for the MACD indicator. Signals are taken when MACD crosses its signal line, calculated as a 9 day exponential moving average of MACD. The MACD indicator is primarily used to trade trends and should not be used in a ranging market. 

The main advantage of MACD Percentage over MACD is the ability to compare indicator values across stocks.

The only difference with MACD Percentage Price Oscillator is that the difference between the fast and slow-moving averages is calculated as a percentage of the slow-moving average:

MACD = (12 Day EMA – 26 Day EMA) / 26 Day EMA

What does Zero Crossover mean?

The MACD line crossing the zero line instead of the signal line is called the zero line crossover. MACD crossing above zero is considered bullish, while crossing below zero is bearish. Traders generally take long positions when the MACD crosses from below the zero line(bullish signal).

Traders see a crossing from above the zero line as a negative indicator, at which point they enter short bets to profit from decreasing prices and accelerating downward momentum.

What does Signal-line Crossover mean?

The MACD line’s 9-day EMA serves as the signal line. Signal line trails the MACD and makes it simpler to identify MACD turns because it acts as the indicator’s moving average. 

When the MACD increases and crosses above the signal line, it is considered a bullish crossover. When the MACD dips and crosses below the signal line, a bearish crossover occurs. Depending on the power of the move, crossovers can endure a few days or a few weeks.

What does Divergence mean?

Divergence is a situation that appears when two lines on a chart move in opposite directions vertically. MACD divergences occur when the MACD forms highs or lows that are above the corresponding highs and lows of the price.

A bullish divergence occurs when a security records a lower low and the MACD creates a higher low. The lower low in the security affirms the current downtrend, but the higher low in the MACD shows less downside momentum.

A bearish divergence forms when a security records a higher high and the MACD line forms a lower high. The security’s higher high is typical for an uptrend, even though the MACD’s lower high indicates less upward momentum.

What does Timing mean?

The MACD is analyzed in three-time frames: 4 hours, 1 hour and 15 minutes. Notice that there is 4:1 ratio between each time frame. The 1-hour and 4-hour MACDs serve as trend filters. The 15-minute MACD gives the buy and short-sell signals.

The 15-minute MACD gives a buy signal when the fast MACD leg (12) crosses the slow MACD leg (26) upwards. As the fast MACD leg crosses the slow MACD leg downhill on the 15-minute MACD chart, a short sell signal is generated. The signals are processed to the combined trend filter consisting of the 4-hour and 1-hour MACD before they are approved.

Only purchase signals are considered if both indicators are bullish. Only short sell signals are approved if both are bearish. All indications are ignored if one is bullish and the other is bearish.

What does False Signals mean?

A false signal is a prediction of price changes that presents a false picture of the state of the economy. False signals can arise due to numerous reasons like timing lags, irregularities in data services, algorithm errors, news, etc.

What does Rapid Rises or Falls mean?

Rapid rise and fall are a sign that security is being overbought or oversold and may act as an entry signal against the short-term trend. The short-term moving average diverges significantly from the long-term moving average, when the MACD rises or falls abruptly, indicating a quick rise. This scenario indicates that the security is either oversold or overbought, depending on whether the MACD is in a positive or negative area.

What is a good number for MACD?

The standard MACD default parameters are (12,26,9), which means:

(12) – The exponentially weighted average (EMA) or “fast line” for 12     periods.

(26) – The sluggish line, or 26-period EMA

(9) – The MACD line’s 9-period EMA, also referred to as the “signal line.”

Where,

MACD =fast line – slow line.

Signal line =MACD’s own 9-period EMA.

The second MACD settings are 19,39,9.

Every MACD has a function,  the fast MACD, which uses the 12, 26, and 9 readings, is used to enter trades at zero-line crossovers.

The slower MACD using the 19, 39, and 9 readings are only to be used to exit the trades when the MACD line crosses the signal line.

Is MACD a good indicator?

Yes, MACD is a good indicator. It enables traders to swiftly and simply determine the direction of the short-term trend. It is easier for traders to confirm that they are trading in the direction of momentum thanks to the obvious transaction signals and crosses over the signal line, which reduces the subjectivity involved in trading.

Is MACD a good indicator for long term?

No, MACD is not a good indicator when it comes to long-term trading. It is, however, sometimes used in long-term trading but MACD provides best results when utilized for short-term trading. The various signals generated by this indicator are easily interpreted and can be quickly incorporated into any short-term trading strategy.

Is MACD enough for trading?

NO, MACD is not enough for trading. MACD helps traders to spot trend reversals, however, it struggles particularly in the sideways market.MACD should be used with other technical analysis tools to get more accurate results.

Is MACD better than RSI?

NO, MACD is not better than RSI. Statistics indicate that compared to the MACD Indicator, the RSI Indicator results in a better trading success rate. This is due to the fact that the RSI Indicator gives fewer false trading signals than MACD.

What is the difference between MACD and RSI?

The MACD measures the relationship between two EMAs, while the RSI measures price change in relation to recent price highs and lows.

The RSI aims to demonstrate whether a market is considered to be overbought or oversold according to recent price levels. The RSI determines the average price gains and losses over a certain time period; the default time period is 14 periods, with values ranging from 0 to 100.

The MACD is used to determine how strongly stock price movement is changing. It does this by measuring the divergence of two exponential moving averages (EMAs), commonly a 12-period EMA and a 26-period EMA

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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