The Moving Average Convergence Divergence (MACD) oscillator is a technical gauge that can help traders to identify emerging price trends, be they bullish or bearish.
Classed as a momentum indicator, the MACD is based on the relationship between two moving price averages on the same asset. Conceived by investment manager Gerald Appel in 1979, the MACD has risen to become one of the most popular technical trading indicators in use today.
The MACD is derived from subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, known as the "signal line", is then drawn. The signal line can be used as a threshold to help define buy and selling opportunities.
The EMA differs from a standard moving average in that greater weight is placed on the more recent data; in this way the EMA responds more quickly to price changes versus a simple moving average.
As it is derived from the actual price changes of the moving averages rather than the percentage changes, the MACD is categorised as an absolute price oscillator (APO) as opposed to a percentage price oscillator (PPO).
When the MACD rises above the signal line, traders view this as bullish and tend to go long on the asset in anticipation of upward momentum.
In contrast, the MACD falling below the signal line is a bearish prompt that traders may act upon to take short positions in the asset as they seek to profit from price falls.
In practice, the crossover signals from the MACD divergence should be supplemented with other technical and fundamental analysis, and at the very least some basic price analysis. For instance, to act on the bullish MACD crossover, when the MACD rises above the signal line, we should look for further confirmation such as the asset price breaching a resistance level.
When the MACD rises sharply, this is often taken as a sign that the asset is overbought or overvalued and could be due for a retrace. This occurs when the shorter-term, 12-day EMA is accelerating away from the longer-term, 26-day EMA.
Conversely, when the MACD falls acutely, this could be a classic case of the asset being oversold or undervalued. When this happens, the shorter-term EMA is fast falling away from the longer-term EMA.
To better determine overbought or oversold conditions, MACD trading is often combined with other technical indicators such as the Relative Strength Indicator (RSI).