MACD: Why do technical analysts like it?
In the previous part of our series introducing technical indicators, we explored the world of moving averages, now we go one step further and take a closer look at the MACD indicator that uses moving averages. The indicator, which is often used in our technical analyses, is typically used to identify trends and possible trend reversals.
The Moving Average Convergence Divergence (MACD) is a momentum oscillator and one of the most versatile technical indicators used in technical analysis. It helps traders identify buy and sell signals, and analyze price action and price movement. The MACD line is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. This MACD line is then plotted with the 9-day EMA of the MACD line, known as the MACD signal line.
When the MACD line crosses above the signal line, it signals a bullish crossover, suggesting it might be a good time to buy. Conversely, when the MACD line crosses below the signal line, it's considered a bearish crossover, indicating a possible sell point. These crossovers can also be depicted in a MACD histogram, which represents the difference between the MACD line and the MACD signal line.
Divergence is another crucial concept in using the MACD indicator. When there's a discrepancy between the MACD line and price movement, it may hint at an upcoming reversal. A bullish divergence occurs when the price hits a new low, but the MACD doesn't, suggesting a potential upward trend. Conversely, a bearish divergence occurs when the price reaches a new high, but the MACD fails to follow suit, indicating a potential downward trend.
Ultimately, how traders use the MACD indicator will depend on their individual trading strategies and interpretation of the MACD chart, MACD crossover, and any divergence signals.
The MACD, or Moving Average Convergence Divergence to give it its full name, is a technical indicator that shows the relative position of two oscillating lines to each other. These lines, as suggested by the name of the indicator, are calculated using exponential moving averages. Unlike moving averages, we do not fit the MACD image to the chart, but typically display the indicator below the chart. In the figure below, we display the MACD indicator under the Apple daily chart:
Elements of the MACD Indicator
The first line is essentially composed of the difference between two exponential moving averages, which are calculated from the closing prices of the financial instrument under examination. This is also called the MACD line, which forms the basis of the indicator. Typically, the 12-day exponential moving average is subtracted from the 26-day average, resulting in the MACD line, which typically performs a sideways oscillating movement around a zero line. It is worth mentioning here that although the time periods can be freely chosen, it is not necessarily advisable to change them.
| MACD Line = | EMA12 - EMA26 |
Then we take the 9-day exponential moving average of this MACD line, thus obtaining the second component of the MACD, the signal line. Typically, the moving average covers a 9-day period, but as with the MACD line, we are free to choose the length of the period under examination.
| Signal Line = | EMA9 of MACD Line |
Understanding Signals and Their Meaning in MACD
The indicator gives several signals, but most often we tend to monitor the relative position of the two lines to each other. If the MACD line is positioned above the signal line on the chart, we can speak of an upward trend, and the opposite is also true, i.e., if the signal line occupies the upper position, it may indicate further decline. It follows that if the MACD line crosses the signal line from below, we can take it as a buy signal, and in the opposite case, we can talk about a sell signal. This crossing is usually observed in relation to the MACD, as investors can maximize yield potential by timely identifying trend reversals.
The difference between the two lines is often represented by a histogram, making the current signal of the indicator easier to read. In the case where the histogram shows a positive value, we can talk about a buy signal, logically in the opposite case, in case of a negative value, the indicator shows a sell signal.
The indicator can also be used to identify overbought or oversold conditions. If the gap between the MACD and the signal line becomes too wide, it usually means that the market has held a certain direction for too long, and the trend may soon reverse. In addition to the above-mentioned signals, crossing the zero line can also provide additional information, as if the MACD line shows an upward trend and crosses the zero line, in many cases it can be trend reinforcing, and of course this is also valid in reverse situations.
Pros and Cons of Using the MACD Indicator
Since the MACD works from moving averages, it logically gives retrospective signals, as averages work from past data. Therefore, the indicator may indicate late in some cases, primarily in the short term it may happen that the indicator changes signal after the price movement, so it is less able to predict trends, but it is more usable for confirming trend movements.
However, there is an advantage to the later signal, as it can send fewer false signals to us than, for example, momentum indicators. But it can't be said that the MACD doesn't give incorrect signals either, if the price is mainly moving sideways, it often happens that several sell or buy signals follow each other, but the price does not follow this. The other common type of incorrect signal occurs when it signals a buy above the zero line, or gives the sell signal below the zero line.
Overall, it can be said that it is effective if we try to interpret the MACD together with several other indicators, also taking into account the picture of the price, and it is worth being aware of the basic fundamental factors.
FAQ
Q: Why do traders use MACD?
A: Traders utilize the MACD as it aids in identifying potential points of buying and selling through signal line crossovers and divergence, which can highlight a forthcoming trend reversal. It also provides insight into the relationship between two price averages, offering a perspective on market momentum and potential shifts in the trend.
Q: How does MACD help in predicting the market?
A: The MACD assists in predicting market movements by indicating possible bullish or bearish trends via crossover points between the MACD line and the signal line. Additionally, instances of divergence between the MACD and price direction can flag potential reversals.
Q: How effective is MACD for day trading?
A: The MACD can be an effective tool for day trading. It helps track short-term price momentum and provides potential entry and exit signals. However, it's important to note that it's typically more effective when used in combination with other indicators and analysis methods.
Q: Is MACD effective for forex trading?
A: Yes, the MACD can be an effective tool for Forex trading. It can help to identify potential buying and selling points, ascertain the strength of a trend, and signal possible reversals. As always, it should be used in conjunction with other technical indicators and analysis techniques for best results.
Q: What is MACD in simple terms?
A: MACD, short for Moving Average Convergence Divergence, is a trend-following momentum indicator that shows the relationship between two moving averages of a security's price. It can provide signals for buying and selling opportunities through its crossovers and divergence patterns.
Q: How does MACD behave in different market conditions?
A: The behavior of the MACD can vary depending on market conditions. In a trending market, MACD crossovers and divergence can provide valuable entry and exit points. In a sideways or consolidating market, however, the MACD may produce many false signals and may be less useful.
Q: Can MACD predict market downturns?
A: While the MACD can't predict downturns with certainty, it can provide signals that a market downturn may be imminent. This is usually signaled by a divergence between the MACD and the price trend or when the MACD line crosses below the signal line.
Q: How do traders interpret MACD histogram?
A: The MACD histogram is interpreted by traders as an indication of the momentum of a trend. When the histogram bars are positive (above the zero line), it indicates a bullish market. Conversely, when the histogram bars are negative (below the zero line), it suggests a bearish market.
Q: How do investors use the MACD?
A: Investors can use the MACD as part of their technical analysis to identify potential buy and sell signals, gauge the strength and direction of trends, and identify possible trend reversals. However, like all indicators, it should be used in combination with other analysis techniques for best results.
Q: What is a bullish MACD crossover?
A: A bullish MACD crossover occurs when the MACD line (the difference between the 12-day EMA and the 26-day EMA) crosses above the signal line (the 9-day EMA of the MACD line). This is often seen as a potential buying signal.
Q: What is a bearish MACD crossover?
A: A bearish MACD crossover occurs when the MACD line (the difference between the 12-day EMA and the 26-day EMA) crosses below the signal line (the 9-day EMA of the MACD line). This is often interpreted as a potential selling signal.
Q: What is a bullish divergence on the MACD?
A: A bullish divergence on the MACD occurs when the price of a security makes a lower low, but the MACD forms a higher low. This divergence can be an indication that the downward trend is losing momentum and a potential bullish reversal could be forthcoming.
Q: What is a bearish divergence on the MACD?
A: A bearish divergence on the MACD happens when the price of a security makes a higher high, but the MACD forms a lower high. This divergence can indicate that the upward trend may be losing strength and a potential bearish reversal could be on the horizon.
Q: How is the MACD signal line calculated?
A: The MACD signal line is calculated by taking the 9-period EMA of the MACD line. This line serves as a trigger for buy and sell signals when it is crossed by the MACD line.
Q: What does a rising MACD line indicate?
A: A rising MACD line can indicate increasing upward momentum in the price of a security. This could be seen as a bullish signal, especially if the MACD line crosses above the signal line.
Q: What does a falling MACD line signify?
A: A falling MACD line can indicate increasing downward momentum in the price of a security. This might be interpreted as a bearish signal, especially if the MACD line crosses below the signal line.
Q: How does the MACD help in trend identification?
A: The MACD can assist in trend identification by showing the relationship between two moving averages of a security's price. When the MACD line crosses above the signal line, it suggests an upward trend. Conversely, when the MACD line crosses below the signal line, it suggests a downward trend.
Q: How does MACD measure momentum?
A: The MACD measures momentum by comparing short-term and long-term price trends through the calculation of two EMAs of a security's price. The difference between these two averages (the MACD line) represents the momentum. If the MACD line is above zero and rising, momentum is positive, and if it's below zero and falling, momentum is negative.
Q: How can MACD divergence be used for trading?
A: MACD divergence can be used for trading by providing signals for potential trend reversals. For example, if the price reaches a new high but the MACD does not, it's a bearish divergence and might indicate a potential reversal to the downside. Conversely, if the price hits a new low but the MACD does not, it's a bullish divergence and could suggest a potential upward reversal.