MACD - Moving Average Convergence-Divergence

“Moving Average Convergence/Divergence” or in short MACD is a technical indicator which is used to analyse the relationship between two moving averages of prices. MACD calculates the difference between two Exponential Moving Averages (EMA) which is considered as a trend-following momentum indicator.

MACD is determined by subtracting the 26-day exponential moving average (also knows as the EMA) from the 12- day EMA. In the next step, a nine-day exponential moving average of the MACD (known as the “single line”) is plotted in the MACD. The traders use this as the signal to buy and sell in the market.

Under this system, if the MACD moves upward then it means the 12 day EMA is trading above the 26 day EMA which implies positive momentum. The stock will be considered “bullish” if the EMA trades above the 9 day EMA trigger line. The stock will be under selling pressure if both lines move downwards.

If the MACD goes above (fall below) the trigger line then the simplest interpretation of a bullish (bearish) moving crossover takes place. A trader may consider that the downward momentum is falling with strong possibility of a reversal in times when the market trends down and the 9-day EMA moves above the MACD.

Interpretation of MACD

MACD can be interpreted in three different ways:

MACD Crossover

Under this method, the market gives a bearish signal when the MACD moves below the signal line sending the message that may be it is the right time to sell the asset. On the other hand, the indicator gives a bullish signal if the MACD exceeds the signal line, indicating that the asset is going to experience an upward momentum in its price. You will find many traders waiting for a confirmed cross above the signal line prior to entering positions in order to avoid getting “faked out”.

MACD Divergence

The signal will indicate the end of a current trend when a security price moves away from the MACD.

Dramatic Rise

The traders consider a security being over bought in times when the shorter moving average pulls itself away from the long-term moving average. This is the time when you will see the MACD rising dramatically.

Zero Crossover

In addition to this, the traders also look forward for a movement above or below the zero line which indicates the position of the short-term average in relation with the long-term average. An upward momentum is indicated when the MACD is above the zero line and the long-term average is below the short-term average. A downward momentum will be indicated if the MACD remains below zero.

False Signals

MACD can give false signals too just like any other indicator and the traders need to make sure that they have enough protection to avoid them as much as possible. The example of a false signal can be a false positive, which would be a bullish crossover- something that will end up with a sudden decline in the value of a share. On the other hand, a false negative will refer to a scenario where the share will suddenly accelerate upwards without the existence of a bullish crossover.

How can Traders Protect Themselves from the False MACD Signals?

There are a number of ways through which a trader can avoid getting trapped by the false signals. One technique is applying a filter for signaling line crossovers to make sure that they will hold. Example of a price filter can be, buying when the MACD line breaks above the signal line and remains above it for three days. The filtering strategy is considered effective for protecting the traders from false signals.

Often you will find traders paring the MACD with a leading indicator like the Relative Strength Index (RSI). The traders may also consider the trend of price s as well as historical comparison between similar shares in order to speculate the future price movements.

Limitations of MACD

One of the main limitations of MACD is that it cannot respond effectively in markets with extremely high or low volatility. Another issue that is needed to be taken under consideration is that MACD calculates the divergence between the averages and therefore is only suitable for providing meaningful feedback when a change occurs in the trends. This is why you may find MACD less effective in markets that are not trending, instead taking unexpected turns.

As far as the sideways market is taken under consideration, the divergence between the averages does not come up with a trend that can be illuminated. And in case of an erratic market, the effectiveness of the MACD can be diminished as the changes take place too quickly which cannot be picked by moving averages or cancel out each other. However, it is to be mentioned that the overall characteristics of a market – whether it is following a certain trend or is a volatile one- is always relative to a particular timeframe and the MACD can be adjusted to shorter or longer spans based on that.

Traders who are relatively more traditional may use MACD to support a stock choice which was determined previously. MACD can be used to identify an appropriate entry-point into a stock as well where that particular stock has to be at a fundamentally sound position.