MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)

The frequently followed MACD is a momentum trend-following tool that shows the relationship between two Moving Averages (MAs) of price. Since it is based on MAs and thus lags price, it has less utility in indicating price trends for assets that are trading erratically or not trading in a range.

Momentum – the tendency of rising asset prices to keep on rising, and for falling prices to continue dropping – is something that financial theorists find difficult to explain, given that an increase or decrease in price in and of itself does not necessarily reflect changes in supply, demand, or new market information. Momentum is often attributed to irrational investor responses reflecting their cognitive biases. Nonetheless, it is a key element in technical trading, and the MACD helps reveal changes in price momentum, direction, strength, and trend duration.

USING THE EMA

MACD is commonly calculated by the use of the exponential moving average (EMA), which reflects the most recent asset price moves. The EMA indicator line will reflect a sustained upwards or downwards trend. Astute traders will keep an eye on both the direction and the rate of change from one bar to the next. The rate of change indicated by the line will follow suit as a strong upward move begins to soften, to the point where it flattens to zero. By this time price action could already be reversing, because it is a lagging indicator. A consistent diminishing in the EMA’s rate of change helps to interpret the lagging effect of MAs.

In practice, the MACD takes the 26- period EMA away from the 12-period EMA, with a nine-period EMA signal line plotted on top, which acts as a trigger signal to buy and sell – i.e. the pre- determined chart levels the technical investor has identified for the duration of the trade. By comparing the different EMA periods, the divergence series can indicate subtle changes in price trends. The MACD is classed as an absolute price oscillator (APO), because it deals with MA prices, rather than their percentage changes as in the percentage price oscillator (PPO).

MACD METHODOLOGY

MACD indicators can be interpreted in a variety of different ways.

FALSE SIGNALS

To ensure they don’t enter a short-term trade before the trend has been established, traders will check the MACD against a varying range of parameters and durations. They need to be aware that MACD can generate false signals, like any other indicator, and so should use a number of different approaches to differentiate between false and true signals. For example, it is prudent to apply a filter to ensure that a signal line crossover trend has held up. But it should be noted that while this may reduce the likelihood of false signals, it could also increase the possibility of missed profits.

DIVERGENCE

The “D” in MACD signals the end of a trend. MACD inventor Gerald Appel described Divergence as the point where two underlying MAs move apart, and it is signaled when price diverges from the MACD. For example, the rise of a currency price against a falling MACD could mean that a rally is about to come to an end. Conversely, a falling stock price against a rising MACD could mean a bullish reversal is in the making. Divergence in conjunction with other technical indicators has become a standard tool for seeking trading opportunities.

EXTREME RISES

This is often used in conjunction with other indicators such as the RSI, to confirm an overbought situation.

CROSSOVERS

Technical indicators such as the MACD use lines to generate buy and sell signals or suggest a change in a trend. Traders often avoid entering a position too early in the trend by waiting for a confirmed cross above the signal line. Signal lines are frequently used together with other technical analysis methodologies such as technical indicators, chart patterns, or candlestick patterns, to confirm trends. When the MACD falls below the line it signals bearish sentiment, suggesting it is time to think about selling. A rise above the line usually indicates an upward price movement and is a bullish signal.

ZERO CROSSOVERS

Zero crossovers take place when the MACD line crosses the horizontal zero axis, meaning the difference between the series’ fast and slow EMAs has been eliminated. A change to a negative MACD is bearish, and the reverse is bullish. These zero crossovers can confirm a change in trend direction, but they offer less evidence of momentum than a signal line crossover.