What is Moving Average Convergence Divergence (MACD)?

MACD is an indicator of price momentum, showing the direction of the stock price is in the market. However, it detects trend reversals only after they happen and hence needs to be used with caution. Investors can analyze the profitability shown by MACD to make decisions regarding the price of a particular stock.

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Key Takeaways

  • The moving average convergence divergence (in short, MACD) is a technical indicator that helps traders pace their entry and exit into the stock market.It helps to analyze the market momentum and trends to minimize losses.The MACD indicator measures the convergence and divergence of two moving averages. The mid-term moving average is subtracted from the short-term moving averages to arrive at this value.MACD crossing the zero or central line is generally interpreted as a buy or sell signal. Typically the central line cutting from the bottom is considered a buy signal.

MACD Indicator Explained

The Moving average convergence divergence concept is a technical analysis indicator for analyzing the stock market. Gerald H. Appel, an active trader and author developed the idea in 1979. It acts as an indicator of the price momentum prevailing in the market. Through this, investors can predict the direction in which stock prices are moving in the stock market. The MACD technique tracks the convergence and divergence between two moving averages. The calculation involves deducting the mid-term moving average from the short-term moving averages. Usually, one takes three values here. The most commonly used ones are the 12-day and 26-day moving averages. The general rule during the choosing of values is that, one should be of a shorter period, and the other should be of a longer period. Exponential moving averages (EMA) helps to calculate these. Calculation done through software such as moving average convergence divergence python can be of immense help.

MACD histogram depicts these values and show the trend. Large bars indicate divergence in a moving average convergence divergence histogram, whereas small bars indicate a convergence of the moving averages. The MACD trend is bullish when the short-term moving averages are above medium-term moving averages and bearish in reverse situations.

Positive and Negative MACD

A positive MACD indicates that the short-term moving averages are above the medium-term ones and, therefore, bullish. Negative MACD thus shows bearish trends. Generally speaking, MACD crossing the zero line or the central line is a buy or sell indication. The zero line from the bottom is a buy signal, and the central line cutting from the top is a sell signal. However, the zero-line crossover rules have a disadvantage; the events occur with a lag. This is because MACD is a trend-following indicator.

There will be lags even if investors or traders increase the sensitivity by selecting shorter moving averages. To avoid this, traders lean towards more complex trading rules such as signal crossover and divergence. However, MACD divergence cannot be the sole indicator of a reversal of prices. This is because MACD trend lines will diverge as soon as the price begins to level out because price momentum cannot last indefinitely.

How to Use MACD Indicator?

The MACD generates the following kind of signals:

The Signal Line Crossovers:

The signal line is the EMA of the MACD. The market is considered bullish when the MACD crosses above the signal line. On the other hand, the MACD line goes down and crosses below the signal line; this is known as a “bearish crossover.”

Centre Line Crossovers:

The trend is bullish when MACD crosses the zero line and goes above. At this point, a buy signal occurs. Conversely, When MACD drops below zero line and becomes negative, it is a bearish centre line crossover. At this trend, a sell signal is generated. 

Divergence:

This happens when the MACD when does not follow the price action deviates. For example, it is a bullish divergence when the price touches a new low, but the MACD does not follow it to confirm by making a new low. Similarly, it is bullish when the price touches a new high, but the MACD does not follow it and makes a new high.

However, MACD indicators do not work in a range-bound market and are thus ineffective. In addition, there can be misinterpretations made in short durations. For example, there can be a negative crossover, but the occurrence of a steep price rise can be seen. Hence, the events have to be looked at for a longer duration to predict real outcomes.

MACD Example

The below example of applying the moving average convergence divergence formula gives readers the basic idea of how the concept works.

MACD calculation can be done by using the following formula:

MACD = EMA 1 (12-day closing prices) – EMA 2 (26-day closing prices)

EMA (t) = α * (Closing Price) t + (1-α) * EMA (t-1) Where α = 2/ (N+1)

Suppose Dan wants to invest in the stock market and analyze recorded data points regarding MACD. Analyzing the data over time, he understands stocks of umbrella corporations that sell umbrellas behave in a certain way over particular seasons. When the autumn season, the umbrellas are not in demand, is about to begin, the MACD tends to turn up and cross above the signal line. This indicates buying time. Dan has to buy the stocks to get them at low prices. When the rainy season came, He observed the MACD going below the signal line. This indicated a sell signal that he could avoid losses and profit by making better choices. For convenience, individuals can attain software’s help investors can use Moving average convergence divergence python for easy calculations.

This has been a Guide to Moving average convergence divergence(MACD) and its working. We discuss how to use MACD indicators, their techniques, and example. You can learn more about it from the following articles –

The trend is considered bullish when the price rises above the average in MACD. Similarly, the trend is bearish when the price goes below and down the moving average. This, however, will vary depending on the circumstances.

MACD is found by giving inputs of two values. One shall be a long-term value and the second a short-term value. The difference set usually is between 12-26 weeks period.

One can check it by using the MACD formula, which is nothing but MACD = EMA 1 (12-day closing prices) – EMA 2 (26-day closing prices) if the values are chosen are 12 and 26.

Investors interpret the analysis of MACD and decide the timing of their investment. For example, they can choose to buy during the bear market and sell during the bull market. This buying or selling strategy can also decide their entry and exit in the market.

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