MACD or Moving Average Convergence Divergence is one of the most popular and widely used technical analysis Indicators. We will try to explain about MACD Indicator and it's use in technical analysis. We will also highlight some unique trading strategies. Please note that the explanation here is focused for Forex trading but the same is valid for stocks or any commodity trading.
Moving Average Convergence Divergence (MACD) indicator was invented by Gerald Appel in 1960s.
Here we will discuss about MACD, it's construction, types of trading signals with examples and also an insight of MACD trading strategies.
Moving Average Convergence Divergence is a momentum Oscillator and can be used to determine the momentum of the price action.
MACD is comprised of two EMAs (Exponential Moving Averages) of two different time periods. One for longer time period and another for shorter period, for example EMA for past 12 periods and for past 26 periods.
MACD is unique as it has lagging indicator elements as well as leading elements.
MACD is a momentum oscillator. If the market is having trend, either up or down, then It tells us whether the momentum of the trend is getting stronger or is it weakening. It may give many false signals when the market does not have a trend and is running sideways. False signals are more when the price movement range is narcontainer.
In trading the momentum is the rate of price increase during uptrend and rate of price decrease during downtrends.
Let's try to have an explanation with an easy example. Let's say we are driving a car and during the travel the speeds have been as follows:
Between 2:00 PM and 3:00 PM the average speed was 100 km/hr.
Between 3:00 PM to 4:00 PM the average speed was 110 km/hr and
During the next hour i.e. between 4:00 PM and 5:00 PM the speed was 111 km/hr.
Now as we see that the average speed has continuously been increasing. We might get the impression that it was an uptrend as average was continuously getting higher. But it would have been an illusion as we did not consider the momentum. If we notice the average speed during the last leg i.e. speed between 4:00 PM to 5:00 PM, we would see that the momentum of increase in the average speed was dying down. This indicated the possibility that during the next leg, the speed might further go down instead of going up.
Momentum takes out the illusion of the trend even if there is a constant upward or downward movement. And it tells us if the rate of change is slowing down or going up. The drop in momentum indicates the possibilities of a reversal in the trend.
Buying is signaled when the uptrend is gaining momentum and selling is signaled when the downtrend starts gaining momentum. MACD helps us in doing so.
Let's consider a bullish market. Before entering the long position we would like to know if the momentum of the upward momentum is maintained or it is slowing down. In case the uptrend is slowing down then the market might be going for a correction or reversal. That would mean that once we buy, there can be a possibility of a downward correction. The vice-versa is true in the downtrend or bearish market i.e. If the downtrend is slowing down and we enter a short position, the downtrend may go for reversal and an upward move may start. Moving Average Convergence Divergence helps us in estimating the momentum of the trend.
During an uptrend we would like to buy when we find out that the uptrend is gaining momentum as in that case we can expect further upwards moves. Similarly in a downtrend we would like to enter a short position when the downward momentum is getting stronger as further drop in the price can be expected. Hence knowing about the momentum of the trend is very important and MACD helps us in determining that.
MACD= shorter term moving average - longer term moving average.
The most common period setting for MACD is 26, 12, 9. Now we will see what does it mean and how MACD is constructed.
Here “26” is EMA of previous 26 periods, “12” is EMA of previous 12 periods. And MACD would be the line constructed by joining the points which we get by deducting EMA(26) from EMA(12). In our case it means MACD = EMA for 12 periods – EMA of 26 periods.
Uptrend: If the EMA of previous 12 periods (more recent data) is going over the EMA of 26 periods (longer time frame data), it would indicate that in recent time the market started moving upward. You may also read about moving averages.
Downtrend: If the EMA of previous 12 periods (more recent price) is going below the EMA of 26 periods, it would indicate that in recent time the prices have started going down.
Now how do we find out the momentum by using MACD? Please see the chart 1 below.
Chart 1:
If we see the above EUR/USD chart, we find that there is one more line which is known as “MACD Signal Line”.
The Signal line is derived by taking the Exponential Moving Average (EMA) of the MACD line. Here with MACD (26,12, 9) we are taking the EMA of MACD for pervious 9 periods.
Now as we know that if the recent Moving Average (short term moving average) is more than the longer term moving average, it indicates an uptrend as it shows that recently the market is going up. But how do we find out the momentum of uptrend i.e. if the trend is strong or weak? We find the momentum by comparing the positive difference of the current period to the average difference. For this purpose we need to find out the average difference. This average difference is nothing but the “average” of the differences for past few periods. In our case (MACD 26, 12, 9) it is the average of the differences over past 9 periods. Every technical analysis indicator has some default or most common settings for time period. It is always advisable to use these standard setting. The reason is simple that majority of traders would be using those settings to buy or sell and hence adding momentum to the price trend in those direction.
With MACD (26,12,9) what we are calculating is as follows:
Opposite of points 1 to 5 above i.e. when the MACD gores below the signal line would indicate the time to sell.
In technical analysis, the main signals we look for are as follows:
When the main line crosses the signal line it gives a signal for change.
MACD main line moves over the signal line:
Such move indicates that the recent upward momentum is more than the previous. Now if the MACD was already in positive range, indicating an uptrend then it would mean that the uptrend is getting stronger. If the MACD was in negative range then it may mean that a reversal or upward correction can be expected. Please check charts 2 & 3 below.
A bullish moving average Crossover occurs when the main line moves above its signal line.
MACD main line moves below the signal line:
Such move indicates that the recent downward momentum is getting stronger than the previous. This is just opposite to the bullish signal we explained above. In this case if the MACD was already in negative range then it indicates that the existing downtrend is getting stronger. If the MACD was in positive range then it signals the possibilities of a reversal or correction of the existing uptrend. Please check charts 2 & 3 below.
A bearish moving average Crossover occurs when MACD moves below its signal line.. This crossover below signals that the market is becoming bearish and it may be the time to sell.
Please keep in mind that MACD works better during a reversal of a trend (uptrend to downtrend or vice-versa) or during the sideways market when the movement range is not very narcontainer
Please take a note of the points A to F in the above chart for EUR/USD:
Point A and associated area within the green circle:
The MACD main line moves over the signal line. This gives a “buy” signal or the signal indicating the possibilities of a correction or reversal of the downtrend.. Please note that before this crossover the MACD was in the negative zone and was representing a bearish market. The price continued moving upwards with minor corrections. .
Point B and associated area within the green circle:
At point “B” the MACD main line crosses over the “Center line”. This again signals that an uptrend may start.
Point D and associated area within the red circle:
At point “D” the MACD line moved below the signal line. This gives a signal that we can expect a downward correction or even a reversal of the uptrend. Please note at before this crossover MACD line was in positive zone and was indicating a bullish market. This was the time to sell the already bought lot for EUR/USD. In case we were not holding any bought position before this point “D”, we could short-sell the currency pair here to benefit from the possible downward move.
Point E and associated area within the red circle:
The MACD line started crossing the signal line upward. This singled that the market may start going up. This signal was not a strong signal as the MACD line did not really move up sharply.
Please take a note of areas within the circles in the above charts. Before each crossover there has been a divergence. For example before the crossover at point D, the MACD line had started moving downwards sharply. Similarly within the area of point “E”, the MACD line had started moving upwards sharply before the actual crossover took place. In the area “C”, the MACD line started moving down but this move was not sharp. These sharp divergences may also indicate the possible change of the trend.
Some of the above mentioned points would become more clear later in this article.
In MACD analysis it is not only the crossover signals but we need to watch the developments of the subsequent highs and lows. When the subsequent high or low points (peaks and valleys) in MACD line are going lower than the previous peaks or lows, it may give a good signal for an emerging down trend. Similarly if the subsequent high and low points in MACD line are going higher than the previous ones, it may give a good signal for an emerging uptrend.
Chart 3:
Chart 4:
Please check about MACD Histogram to see what is this indicator and how to use it in technical analysis.
Please also check more explanation about MACD Divergence and it's use in trading.
We have also tried to mention about some research on revised MACD trading strategies to avoid number of false trading signals.
You may also like to check some of our trading strategies by combining MACD with RSI and SAR for better trading decisions.
You may also check some good videos about MACD.
We have explained about MACD in the context of technical analysis for Forex trading but it can be used in the same way for stocks or any commodity trading.
