James HesterThe 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.
Signal line
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).
MACDCrossovers
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.
MACD rise
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).
Divergence
A MACD chart can also help identify instances where an existing trend is coming to an end. When a stock price is falling but the MACD is rising, this could mean that a down phase is at an end and a bullish price rally is just around the corner.
In contrast, when a stock price is rising but the MACD is falling, then the current uptrend could be coming to an end, with a bearish retrace in the offing.
MACD bullish divergenceFalse signals
As with any technical indicator, the MACD may on occasion provide false signals. For instance, suppose the MACD rises above the signal line only for the asset price to subsequently fall. Conversely, suppose the MACD falls below the signal line only for the asset price to then rise.
Price analysis, and the supplementary use of other fundamental research and technical indicators, should help improve the reliability of the MACD signals.
However, another means by which to gain additional confirmation on the strength of the signal is to stipulate that the MACD must have moved through the signal line for a certain minimum amount of time before we act. The period applied should vary according to our trading frequency.
Short-term, intraday traders may stipulate that the MACD stays above or below the signal line for one or two hours before they act. Those implementing trades over longer-term time frames may want the signal to last for at least a few days.
But, by imposing such an additional requirement, there is always the risk that we could miss out on some of the profits from the MACD signal as we bide our time.
Powerful indicator
The MACD can be a powerful technical indicator, helping us to identify opportunities to go long or short in assets. As with other technical indicators, it’s important not to use the MACD in isolation.
Along with fundamental information such as news flow, MACD signals can be used in combination with a variety of other technical indicators to help us make better trading decisions. As when trading with other technical indicators, it’s advisable to use a stop loss with the MACD.
