What is an MACD?
The acronym for MACD is Moving Average Convergence Divergence and chart analysts like to call it ‘Mac-Dee’. The MACD is a type of technical indicator invented by Gerald Appeal in 1979. It is used to pin point moving averages that are indicating a new trend either bullish or bearish.
Because the MACD is a trend-following price actions indicator, it indicates the relationship between the values of the two moving averages. It is computed by deducting the 26-day EMA from the 12-day EMA. Closing prices are applied for these two moving averages. The 9-day EMA of the MACD which is known as the ‘signal line’, is then plotted above the MACD, its purpose is to act as a signal for traders to buy and sell. The signal line or MACD line is represented in a form of a histogram in the trading chart. When the MACD line rises on top of its signal line, the histogram is positive and when the MACD line drops beneath the signal line, it is negative. The chart on the right shows an example of the MACD.
You can use the following three methods to explain the MACD:
- Crossovers – When the MACD drops beneath the signal line, it is considered a bearish signal and it means that you have to close your trade or time to sell. On the other hand, when the MACD moves up above the signal line, it indicates a bullish signal hinting that the price asset is about to move uptrend. Most traders would want to wait for the price to move up above the signal line as a confirmation before entering the trade so as to avoid getting a false signal (‘fake out’) or entering the trade prematurely.
- Divergence – The MACD will indicates the end of the present trend when the security price diverges from it.
- Dramatic rise – When the MACD moves up dramatically, meaning the shorter moving average moves away from the longer period moving average, it indicates that the price is overbought and will soon move back to its original levels.
Traders also look out for the price to either move up or below the neutral line or zero line as this will indicate the position of the short term average against the long term average. When the MACD is below the zero line, the short term average is below the long term average, indicating a downward momentum. The reverse is also true when the MACD move above the zero line.
The MACD indicator or oscillator is unique as it consists of two indicators in one that is the momentum and trend-following. This special blending of indicators can be used on any time frame of the trading chart. The normal MACD setting is the difference between the 12-day EMA and 26-day EMA. Traders who prefer more sensitivity might apply a shorter short term and a longer long term moving averages. For instance, the 5,35,5
MACD has more sensitivities than the 12,26,9 MACD. However, for less sensitivity traders could try lengthening the moving averages. Less sensitive MACD still move up or below the zero line but there will be fewer crossovers.
The MACD is not meant for pin pointing the overbought level and the oversold level. Although it can pin point these two historical levels, the MACD does not possess any limits to hold its movement. When the market moves sharply, the MACD might continue to extend further from its past extremes.