What is Moving Average Convergence Divergence (MACD)

MACD stands for Moving Average Convergence Divergence, and it is a technical analysis indicator used to identify changes in the momentum, direction, and trend strength of a security or asset. It is essentially an indicator made up of the convergence and divergence of two moving averages.

Developed by Gerald Appel in the late seventies, MACD helps identify the two most important parameters of technical analysis: trend following and momentum.

To put it simply, MACD is a simple yet highly effective and successful momentum indicator, especially when it complements the price action of the markets.

How to calculate the MACD?

The indicator works by comparing two moving averages of the stock's price, one that is calculated over a shorter period of time and another that is calculated over a longer period of time.

Let’s now look at how to calculate the MACD indicator, which is done in three steps:

• MACD Line: The MACD line represents the difference between the short-term and long-term moving averages, and it's used to identify changes in the trend and momentum of the asset. The MACD line is the difference between the 12-period and 26-period exponential moving averages (EMA). The 12-period EMA is a shorter-term and faster-moving average that is more reactive to changes in price, while the 26-period EMA is a longer-term and slower-moving average that provides a broader view of the asset's trend and is less reactive to price changes. By subtracting the longer-term moving average from the shorter-term moving average, the MACD indicator can identify when the shorter-term moving average crosses above or below the longer-term moving average, which can indicate changes in trend and momentum.
  • When the MACD line is above zero, it indicates that the short-term moving average, that is the 12-period EMA is above the long-term moving average, that is the 26-period EMA, which indicates bullishness in the market.
  • Conversely, when the MACD line is below zero, it indicates that the short-term moving average (12-period EMA) is below the long-term moving average (26-period EMA), which indicates a bearish signal.
  • Signal Line: The signal line is a 9-period exponential moving average of the MACD line. The signal line smooths out the MACD line, making it less volatile and providing a clearer picture of the trend. It's used as a trigger for potential buy or sell signals when it crosses the MACD line.
    • When the MACD line crosses above the signal line, it generates a bullish signal, indicating that it may be a good time to buy the stock.
    • Conversely, when the MACD line crosses below the signal line, it generates a bearish signal, indicating that it may be a good time to sell the stock.
    • Histogram: The histogram in MACD (Moving Average Convergence Divergence) is a visual representation of the difference between the MACD line and the signal line. It's a vertical bar chart that fluctuates above and below the zero line, representing the degree of divergence or convergence between the two lines. The histogram's height reflects the magnitude of the difference between the MACD line and the signal line.
      • When the MACD line is above the signal line, the histogram is positive, indicating bullish momentum.
      • When the MACD line is below the signal line, the histogram is negative, indicating bearish momentum.

Here's the formula to calculate the MACD:

• MACD Line = 12-period EMA - 26-period EMA
• Signal Line = 9-period EMA of MACD Line

But why do we use 12, 26, and 9 as our parameters for these lines? The default settings in all trading software are set as 12, 26, and 9 days. Though the answer to this assumption is best known to Gerald Appel, the MACD's creator, of course, nothing is preventing you from altering the settings. The aforementioned adjustments, however, appear to have become "stuck" with the indicator.

The MACD indicator can be seen in the lower panel of the following chart:

The blue line is the MACD line (the fast line), while the red line is the slow signal line. The bars oscillating around zero is the MACD-histogram.

The idea behind the MACD is simple:

The intensity of a trend is indicated by the distance or size between a shorter and longer-term moving average (MA). Additionally, it indicates the strength or momentum of the trend.

The essential idea is that a shorter-term moving average just accounts for recent price movement, whereas a longer-term moving average accounts for recent price movement as well as older price movement.

If there is a clear separation between these two MAs, it indicates that the recent price action is diverging from the earlier price activity. This shows that the market is either heading upward or downward.

Interpretation

To interpret the MACD indicator, you need to look at its components and how they interact with each other. Here are some guidelines for interpreting the MACD:

1. Crossovers: The most basic signal generated by the MACD is a crossover of the MACD line and the signal line. When the MACD line crosses above the signal line, it's a bullish signal, indicating that the trend is changing to the upside, and it might be a good time to enter into a long trade. Conversely, when the MACD line crosses below the signal line, it's a bearish signal, indicating that the trend is reversing to the downside, and it might be a good time to short the stock or exit from a long position.