The “Mac-Dee” or Moving Average Convergence Divergence (MACD) is a popular indicator often used in successful trading setups. Many self-sufficient traders rely on the MACD, in addition to other indicators, to trade successfully.
In this guide, we’ll go over what the MACD is, how it works, key patterns to look out for, and ways to leverage it in your trading strategy.
- The moving average convergence divergence (MACD) gets calculated by subtracting a shorter-term exponential moving average (EMA) from a long-term EMA.
- The main components of the MACD are the MACD line, signal line, and histogram.
- Commonly used methods to interpret the MACD are crossovers, divergence, and rapid rises/falls.
- The MACD is used to help traders identify changes in the current market direction and signal when the momentum is shifting. However, it has its limitations.
What is Moving Average Convergence Divergence (MACD)?
The MACD oscillator is a simple and effective tool created by Gerald Appel in the late 1970s as a resource for the technical analysis of various financial securities. For the comparison between fundamental and technical check out here. Retail and institutional investors use the MACD as a traditional charting tool to identify trends and anticipate future price action.
Components of the MACD
One of the reasons why the MACD is so popular among traders is because it acts as an indicator of trends and momentum. Essentially, it combines two trend-following exponential moving averages (EMAs) and converts them into a momentum oscillator.
The MACD indicator shows the relationship between two EMAs of a security’s price. It is calculated by taking a slower EMA and subtracting it from a faster EMA. The result is the MACD line, which gets plotted against the EMA of the MACD, or the “signal line.” Traders can then use it as a trigger for buy and sell signals. For more info, you should read on how long does it take to sell stocks. If a trader wants to display a histogram, that gets calculated by subtracting the signal line from the MACD line.
The three main elements of a standard MACD are:
- MACD Line: (12-period EMA – 26-period EMA) Used to help traders identify bullish and bearish trends
- Signal Line: (9-period EMA of the MACD line) Used with MACD line to spot trend reversals and potential entry and exit points
- Histogram: (MACD line – Signal line) Provides a visual representation of the convergence and divergence of the MACD line and the signal line
While 9, 12, and 26 are the most frequently used periods, you can change the periods used based on your trading strategy.
Generally, MACD interfaces get split into two sections. In our example below using Adobe stock, we can see that the upper half contains a candlestick chart that tracks the price of a security over a specified period. The lower half is the MACD graph.
When looking at MACD on a graph, we can see that it has two lines – the MACD line (in orange) and the signal line (in blue). The MACD line is known as the faster line and consists of the closing prices of two periods (typically 12 and 26 days or weeks). The signal line is known as the slower line and involves the EMA of a period of closing prices of the security (typically 9 days or weeks).
If we look at the chart, we can see that the MACD line typically follows the trend of the security’s price, so it can appear a bit choppy. Meanwhile, the signal line helps smooth out the MACD line.
One of the reasons why the MACD is considered an oscillator is because it oscillates around the zero line, or divergence line. When the MACD crosses above zero, that is a bullish sign. When it crosses below zero, that is a bearish sign. Secondly, when the MACD crosses from below the signal line to above it, that is a bullish indicator. Vice versa, when the MACD crosses from above the signal line to below it, that is a bearish indicator.
Similar to many other technical indicators, you generally do not need to calculate the MACD yourself. All you need to do is select the parameters on the investment or trading software you are using. In our case, we added the indicator on Webull and chose the fast length, slow length, and signal smoothing length.
The MACD histogram is a graphical representation of the average fluctuations in the price of a security. When using the MACD, you should factor in the bars’ position relative to zero and the slope of the bars.
When the bars are above zero, there is a bullish trend. When the bars are below zero, there is a bearish trend. Each bar in the histogram represents the difference between the two EMAs on that specific date.
- When the bar is at zero, that means the two EMAs have zero difference between them.
- When the bars grow taller in either the positive or negative direction, the difference between the two averages is increasing (divergence). This divergence usually happens when the MACD is accelerating in the direction of the market trend.
- When the bars start shrinking, the difference between the two averages is decreasing (convergence). This convergence usually results from a change in the direction of a security’s price (potential reversal) or a slowdown in the market. You can see the MACD line get closer to the signal line when this happens.
When the bars form an upward slope, the buyers are in control. When the bars form a downward slope, the sellers are in control.
If the MACD line has a positive value, the shorter EMA is above the longer EMA. The further away the shorter average is from the longer average, the larger the increase in the positive value, which indicates strong upside momentum. Vice versa, if the MACD line has a negative value, that means the longer EMA is above the shorter EMA. As the lines diverge further away, the greater the increase in the negative value, which indicates strong downside momentum.
There are many ways to interpret MACD indicators. Some standard methods include crossovers, divergence, and rapid rises/falls.
The primary method to interpret the MACD is through crossovers.
Signal Line Crossover
The signal line crossover is one of the most common signals that the MACD produces and often gets used for timing trades. As the name indicates, it happens when the MACD line crosses above or below the signal line.
When the MACD falls below the signal line, that is a bearish indicator, meaning it may be time to sell your position. When the MACD rises above the signal line, that is a bullish indicator of the security’s price likely having upwards momentum. Sometimes, a trader may wait for the MACD to cross above the signal line before entering a position to avoid getting “faked out” and entering a trade prematurely.
Usually, if a crossover conforms to the prevailing trend, it’s more reliable. For example, if the MACD crosses above the signal line after a brief correction within a long-term upwards trend, it’s a bullish signal. If the MACD crosses below the signal line after a short move higher within a longer-term downwards trend, it’s a bearish signal.
However, sometimes these signals are not as clearcut as we would like. For example, if the crossover happens at an extreme MACD value (based on previous highs and lows), that could be a false signal. Depending on how volatile the security is, signal crossovers may happen more or less frequently.
Zero Line Crossover
The zero line crossover, or “centerline crossover,” happens when the MACD crosses the zero line and becomes either positive or negative depending on the direction it crosses the line. If the MACD crosses above the zero line, it becomes positive and is a bullish signal. If the MACD crosses below, it becomes negative and is a bearish signal.
When the crossover happens far below or above the zero line, it’s more significant. The area below the zero line represents the oversold zone, so the further away we are from the zero line, the more oversold the security is. When the MACD line crosses above the signal line from far below, it’s a bullish signal.
Vice versa, the area above the zero line represents the overbought zone, so the further above we are from the zero line, the more overbought the security is. When the MACD line crosses below the signal line from far above, it’s a bearish signal.
Another popular signal that the MACD generates is the divergence, which can mean three different things (confusing, we know).
1. The first divergence is exhibited by the MACD line itself. When the two underlying EMAs used to calculate the MACD move future apart, the MACD will rise or fall faster.
2. The second divergence is seen in the histogram. The histogram bars will appear longer when the divergence between the MACD and the signal line becomes greater.
3. The third divergence happens when the MACD line and the price of the security move in the opposite direction. For example, let’s say that there are two highs on the graph of a security’s price and the price experiencing a higher high the second time. At the same time, the MACD exhibits two high points, but the second high point was lower than the first (a lower high). This difference is the divergence.
The two types of MACD divergence are bullish divergence and bearish divergence. A MACD bullish divergence happens when the security’s price moves lower while the MACD moves higher. When this bullish divergence occurs, it indicates that the bottom for the price has set, and it is more likely to rise in the future. A MACD bearish divergence happens when the price moves higher while the MACD moves lower. When this happens, it indicates that the top for the price has set, and it is more likely to fall.
Sometimes traders will try to look for bullish divergences even though the long-term trend is negative because that can signal a potential change in the trend. Other times, traders will focus on bearish divergences even though the long-term trend is positive because that can signal weakness in the trend. However, both techniques are less reliable than looking for a bullish divergence during a bullish trend or a bearish divergence during a bearish trend.
Rapid Rises or Falls
When the MACD rises or falls quickly, meaning the shorter-term MA pulls away from the long-term MA, that signals that the security is getting overbought or oversold. When that happens, traders expect the volume traded to return to normal levels and reflect in the price action.
Sometimes traders will use the MACD alongside other indicators, such as the relative strength index (RSI), to confirm that a security is overbought or oversold.
MACD vs. Relative Strength Indicator
The relative strength indicator (RSI) is an oscillator that measures price changes of a security in relation to previous price levels (namely, recent highs and lows). It helps signal whether a security is oversold or overbought by calculating the average price gains and losses over a specific period, with 14 periods as the default period and values bounded from 0-100.
While both the MACD and RSI are used in trading setups to measure momentum, they measure different factors. Because of this, they can occasionally lead to contradictory indications. For example, the RSI may signal that a security is overextended to the buy-side while the MACD signals that the buying momentum is still rising.
Using MACD to Trade
The MACD is supposed to help you identify changes in the current market direction and signal when the momentum is shifting. However, in practice, traders often use the MACD histogram to track the magnitude of price changes rather than their direction. When the upside momentum slows down, that is a bearish signal, and when the downside momentum slows down, that’s a bullish signal.
While a MACD crossover, convergence, divergence, or rapid rise/fall can be helpful for trading, using other technical indicators will help confirm bullish or bearish sentiment in the specified period. For example, the candlestick chart shows patterns and highs and lows for the specified period, complementing the MACD. Other relevant indicators include support and resistance, Level 2 data, VWAP, etc.
Test Your Trading Ideas with Paper Trading
Once you’ve laid out a few theses for trading, make sure to test them out through paper trading before using real money. It’s easy to look at a few charts, identify key patterns, and think that you’ve nailed all the ins and outs of the MACD. There is no guarantee that you will make money after a couple of trades, but getting a feel for the markets will help you better understand how your trading strategies stack up against reality.
Limitations of MACD
While the MACD is a great tool when used correctly, it has its limitations.
False Positive Divergence
Using divergence has its limitations, as it can predict reversals that don’t actually happen or miss out on ones that do. For example, it can signal that there will be a potential trend reversal, but it doesn’t happen – a false positive divergence.
A false positive divergence usually happens when the price of a security moves sideways. This sideways movement or slowdown in momentum of the price causes the MACD to away from the prior extreme and move towards the zero lines even though there is no reversal happening.
The data used in the MACD is based on a security’s historical price action, making it a lagging indicator. Likewise, moving averages rely on historical data. While these indicators give traders ideas about momentum and price action, they do not perfectly predict the future.
Sometimes something unexpected can happen, causing the price to fluctuate drastically away from the trend. It’s crucial not to overattribute data to the MACD or view it as a crystal ball. Instead, use the MACD and other technical indicators as guides for forecasting.
The Bottom Line
Like other technical indicators, the MACD is a handy tool to incorporate into your trading strategies, though it’s not perfect. Once you understand how the MACD works and test it out with your trading setups, you can then figure how to best leverage it to your advantage.