What is a MACD indicator?

This guide is dedicated to explaining MACD (Moving Average Convergence Divergence) indicator essentials. One of the most commonly used tools for technical analysis, it’s used by both beginners and seasoned traders. We will dwell upon the ways to calculate it, rules of reading and trading strategies where it is used.

The MACD indicator enables us to define trading signals like a crossover or a divergence. By adding it to your trading tactics, you will be able to predict upcoming trends and boost efficiency of your trading decisions. All in all, the earlier you detect market sentiments, the better you handle deals.

What is MACD?

MACD is one of the most commonly used instruments by traders who wish to control risk, strengthen their knowledge of a market, and keep tabs on market trends.

MACD is a financial indicator used for stock market transactions. Based on a particular calculation formula, it defines the best way for an investor to carry out profitable trading operations on the financial markets, and therefore to generate potentially significant capital gains during purchase and sale deals. The MACD is an integral part of technical analysis, one of the analytical methods specific to the financial markets. Use of this indicator boils down to the in-depth study of price charts for strategic purposes: to better understand the trends of a market also means being able to anticipate its developments.

Visually, MACD is represented as two lines oscillating without boundaries. The shooter line is a 12-period EMA (Exponential Moving Average) that reacts to market changes quicker, and the longer line is a 26-period EMA that reacts to price fluctuations slower. The combination of these trend-following lines becomes a momentum oscillator that is used to define the beginning of a bearish or a bullish trend.

EMAs revolve around the zero line and keep crossing, diverging and converging. By tracking these movements, traders can search for trading signals called ‘crossover’, ‘centerline’ and ‘divergence’.

How does MACD work?

The indicator is based on three components:

1. Line (the “MACD”).
2. Line (the “Signal Line”).
3. Histogram.

The first line, the Moving Average Convergence Divergence indicator displays the difference between two moving averages, typically the 12-period EMA and 26-period EMA.

The second “Signal Line” is the moving average of the first line. Usually, it’s a 9-period EMA. In other words, it’s the moving average of the MACD. Hence, the “Signal Line” is slower.

When these two lines get close, they ‘converge’, when they are moving away from each other, they are ‘diverging’. When the MACD moves above the zero line, we may witness an uptrend. When it goes below the zero line, it shows a downtrend.

MACD Formula

To create a MACD line, you should first enable the exponential moving average (EMA) - it will be the basis of the MACD calculation. We will have to distinguish two exponential moving averages each having a distinct period, then calculate the difference between these two averages. The most common and recognized way is to define an exponential moving average at twelve days and another at twenty-six days.

Next, you need to subtract the long-term EMA from the short-term EMA which gives you the Moving Average Convergence Divergence. Use the closing prices of each period:

MACD = 12-period EMA – 26-period EMA

Now, you need to observe the signal line. Use the 9-period EMA to generate trading signals and define turning points in the trend. Lastly, you observe the histogram - the distance between the MACD and the signal lines. The histogram goes above zero when the MACD is above the signal line, and vice versa.

How to read the Indicator?

The signal line as well as the histogram will be calculated automatically. These are the two most important elements of this indicator that traders rely on for their decision making.

The histogram will materialize the amplitude of the difference between the two curves: MACD and signal line. So when the histogram is green, the MACD is above its signal and when it is red, the opposite is true. It will also highlight the cross when the histogram is zero. The slope of the histogram helps traders to define whether the buying or selling trend is dominant and reveal a momentum to determine trend reversals.

You must therefore combine several analyzes simultaneously:

• If the histogram and the signal line are below the 0 level, the trend is bearish. Conversely, if these two curves are above the 0 level, the trend is bullish.
• When the blue line (MACD) crosses the orange line (signal line) upwards, you are theoretically facing a buy signal. If this same blue line crosses below the orange line, you get a possible sell signal. In both cases, it signifies a changing balance between buyers and sellers, a sign of a trend change to come.

Note that these elements alone are not enough, you should confirm these interpretations by analyzing your price charts!

There are combinations of very relevant and effective indicators. As such, the combination of the MACD with the RSI (Relative strength index) or the MFI is a classic choice for traders. The MACD shows trend strength and direction. The RSI, in its turn, is an indicator of potential future variations in the price: it allows detecting overbought and oversold areas.

First, you should understand what each element signifies:

• MACD line allows traders to define upcoming bullish and bearish trends.
• Signal line (9-period of the MACD) is analyzed additionally for traders to spot trend reversals and reveal the best entry and exit points.
• Histogram (MACD - Signal Line) is a graphic depiction of convergence and divergence periods of the two lines.

Each line has a separate value. When the shorter EMA is above the longer EMA, the MACD line has a positive value. The further the distance between them, the bigger the increase in the positive value of the MACD line - it’s a sign of an uptrend gaining momentum. When you see a shorter line below the longer one, this signifies a negative MACD, or a downside movement on the market.

Limitations of MACD

The major problem of the MACD indicator is that it can often signal a possible trend reversal when it’s not actually happening. This situation is called ‘false positives’. In fact, divergence does not necessarily guarantee a price reversal - only their possible occurrence.

False positives are a common thing when asset price is moving sideways and following a trend, for example, a triangle pattern. A pause or slow moves in the momentum can be the reason for MACD to diverge from its previous extremes and gravitate toward the centerline.

How to Trade MACD

Let’s observe the ways to analyze the MACD indicator: they will help you define short-term price moves and established trends.

But before we start, mind a few points:

• The MACD is mainly used to study and follow the trends of certain prices over a given period. It can also be used to analyze trend reversals and better understand these pivotal periods.
• For more efficient analysis, it is advisable to overview the MACD indicator over different periods, not over just a single one.
• MACD should be used together with other financial tools. Using the MACD alone to design a trading strategy can be risky, and it is recommended to opt for a more comprehensive approach for technical analysis.

Zero Line Crossover

Here, things are simple:

• When MACD rises above zero, the trend may be bullish.
• When MACD dives below zero, the trend may be bearish.

On the chart below, you can see the line going below zero - MACD follows price movements.

MACD / Signal Line Crossovers

By analogy with other crossover strategies, traders are advised to buy an asset when the faster line crosses above the slower line. And vice versa for a sell signal - when the faster line crosses under the slower line (as you can see on the MACD chart below).

Here, the MACD line is the faster one (blue), and the Signal line is the slower one (red):

Histogram Reversals

Histogram shows the divergence between the MACD and the Signal Line. The further its bars move away from the zero, the larger is the distance between MACD and the Signal Line. How to use it for analysis?

When the Histogram increases its height, the asset price is gaining momentum (bearish or bullish), and when it shrinks - the trend is weakening. When the first momentum surge ends, you will see a mound or a hump formed by the Histogram.

MACD Divergence

The divergence between the MACD and the price is a signal that shouldn’t be neglected. MACD follows the asset’s cost and repeats its highest highs and lowest lows. But when they don’t move in the same direction, it is called ‘divergence’. MACD Divergence signals a possible trend reversal.

Pros and cons of MACD

MACD vs. RSI

Along with MACD, traders often use RSI (Relative Strength Index) for analysis. Both indices serve to find out the momentum of the trend and define general price direction. However, they work with different aspects.

In order to analyze RSI, traders look at its value that varies from 0 to 100. When RSI gets below 30, it means that the market is oversold and the asset’s price may rise in the near time. On the opposite, RSI above 70 signifies that the asset is overbought and its price is expected to fall.

While Moving Average is based on the divergence and difference between EMAs, RSI is used to evaluate price changes by comparing price highs and lows over a certain period. The RSI indicator helps traders determine the strength of the current market trend, as well as possible spots for price reversal. Since these indicators are built upon different factors, they may generate completely opposite signals.

MACD RSI Indicator

The MACD RSI indicator is nothing more than an RSI indicator that is laid above the MACD indicator. Both of these oscillators provide quite good signals for trading and in combination, they can display price reversal and divergence even more clearly, especially in short periods of time.

As a rule, MACD is used as a trend indicator, as it is quite slow and its signals are often late.
But RSI, on the contrary, is a very fast oscillator and therefore gives a lot of false signals due to its high sensitivity to price fluctuations.

Therefore, the MACD RSI indicator includes the advantages of both of these oscillators.

Summary

MACD indicator is one of the basic indicators that should be included in your trading arsenal. It allows you to follow market trends and identify possible reversals. Despite a simple formula for its calculation, you don’t even need to operate numbers: this tool is always included in charts provided by trading terminals.

By using MACD in combination with other powerful tools, you will be able to make more accurate trading predictions, keep tabs on trends and define correct entry or exit points for your deals.