Traders in the financial markets often struggle to capture the opportune moment to buy or sell. Markets are inherently unpredictable and can swing rapidly in unexpected directions. Consequently, traders typically turn to fundamental analysis (studying economic and financial factors) and technical analysis (observing statistical trends from trading activity) to inform trading decisions. One such technical analysis tool that has shown itself to be valuable for many traders is the Moving Average Convergence Divergence (MACD) indicator.
In this article, you will learn about the MACD indicator, how it works and the trading indicators it can provide.
What Is the Moving Average Convergence/ Divergence (MACD) Indicator?
The Moving Average Convergence Divergence (MACD) is a momentum oscillator widely used in technical analysis to track market trends. It gauges the strength, direction, momentum and duration of an asset's price trend.
What Problems Do MACD Indicators Help to Solve?
The MACD indicator helps traders identify trends in the market and can be used to generate buy and sell signals. It measures the momentum behind these trends, allowing you to determine if a trend might be gaining or losing steam.
Using MACD, traders can also spot divergencies — when the price of an asset moves in the opposite direction of a technical indicator like MACD. Divergencies often occur before a trend reversal, which alerts you to possibly profitable trading opportunities.
How Does the MACD Indicator Work?
The MACD indicator tracks the relationship between two moving averages of a security's price: the 12-day and 26-day Exponential Moving Averages (EMAs). These averages are used to create the MACD line and the signal line.
The MACD line measures the momentum of the price trend and is calculated by subtracting the 26-day EMA from the 12-day EMA. The signal line is the 9-day EMA of the MACD line and acts as a possible trigger for buy and sell signals. It responds slower to price changes than the MACD line, given that it's an average of the MACD line.
The MACD indicator features the MACD histogram — a visual representation of the difference between the MACD and signal lines. This visualization can help traders forecast when a crossover might occur. For instance, when the MACD line crosses above the signal line, the histogram will turn positive, indicating a bullish signal. Conversely, when the MACD line crosses below the signal line, the histogram turns negative, signaling a potential bearish trend.
MACD Trading Signals
Traders use MACD signals to identify their potential entry and exit points in the market.. Let's explore each of these.
1. Signal Line Crossover
A bullish crossover occurs when the MACD line crosses above the signal line. A bearish crossover is marked by the reverse.
2. Centerline Crossover
The MACD centerline is where the values of the two EMAs used to compute the MACD (12-day and 26-day) are equal. When the MACD line crosses the centerline from below, it's a bullish signal. When it crosses from above, it's a bearish sell signal.
3. Divergence
This occurs when the price of an asset is moving in the opposite direction of the MACD. It is a bearish divergence if the price is making higher highs, but the MACD line is making lower highs, possibly indicating a coming price drop. Conversely, if the price is making lower lows, but the MACD line is making higher lows, it's a bullish divergence, indicating a possible price rise.
How Do You Read the MACD?
Reading the MACD effectively involves understanding its three main components: the MACD line, the signal line and the histogram.
1. The MACD Line
Created by subtracting the 26-day EMA from the 12-day EMA, the MACD line can help you identify the momentum and direction of the market trend. When the MACD line is above zero, the 12-day EMA is above the 26-day EMA, suggesting upward momentum or a bullish market. When the MACD line is below zero, the 12-day EMA is below the 26-day EMA, indicating downward momentum or a bearish market.
2. The Signal Line
This is the 9-day EMA of the MACD line. It serves as a trigger for potential buy and sell signals. When the MACD line crosses above the signal line, it gives a bullish signal suggesting it might be a good time to buy. When the MACD line crosses below the signal line, it provides a bearish signal indicating it might be a good time to sell.
3.The Histogram
The MACD histogram represents the difference between the MACD and signal lines. If the MACD line is above the signal line, the histogram will be above the MACD's zero line. If the MACD line is below the signal line, the histogram will be below the MACD's zero line. The histogram can help traders visualize the degree of divergence between the MACD and signal lines. Larger bars mean a larger divergence between the two lines.
The MACD Cheat Sheet
Here is a handy reference guide for understanding and interpreting the most common MACD signals.
1. MACD Crossing the Zero Line
The MACD crossing the zero line is known as a centerline crossover, indicating that the two EMAs used in calculating the MACD (the 12-day and 26-day) are equal. If the MACD line crosses the zero line from below, it's a bullish signal. If it crosses from above, it's a bearish signal.
2. MACD Crossing the Signal Line
When the MACD line crosses the signal line, it generates a potential trading signal. If the MACD line crosses above the signal line, it's bullish; if it crosses below, it’s bearish.
3. Distance of MACD/Signal Crossings from the Zero Line
The distance of the MACD and signal line crossings from the zero line can provide information about the strength of a trend. If a crossover happens far from the zero line, it generally indicates a strong trend, while a crossover close to the zero line hints at a weak or emerging trend.
4. Trading Ranges and Whipsaws
In a sideways or range-bound market, the MACD indicator can often produce false signals or whipsaws. This situation occurs when the price fluctuates within a specific narrow range, causing the MACD line to cross above and below the signal line frequently, leading to potential false buy and sell signals. To try to avoid falling into this trap, consider using MACD along with other indicators that can help confirm the trend.
5. Divergences That Help Identify Reliable Crossover Signals
The divergence between the MACD and the price of an asset can sometimes signal an imminent trend reversal. A bullish divergence occurs when the price forms lower lows, but the MACD forms higher lows — a potential upward reversal in price. A bearish divergence occurs when the price forms higher highs, but the MACD forms lower highs — a possible downward reversal in price. Recognizing these divergences can help traders identify the most reliable crossover signals.
Possible Pros of Using the MACD Indicator
- Trend identification: The MACD can be an excellent way to identify short-term and long-term price movement trends.
- Signal for entry and exit points: The MACD generates clear signals for potential entry and exit points. A bullish crossover (MACD line crosses above the signal line) suggests a possible buying opportunity, while a bearish crossover (MACD line crosses below the signal line) indicates a potential selling point.
- Divergence detection: The MACD can help spot divergences between price movements and the indicator, which can often precede trend reversals.
Things to Consider with the MACD Indicator
- False signals: The MACD can sometimes suggest a buy or sell signal that doesn't forecast accurately, leading to potential losses. This can be especially true in volatile or sideways-moving markets.
- Lagging indicator: Like all moving average-based indicators, the MACD is a lagging indicator. This means it's better used for confirming trends rather than predicting new ones. By the time the MACD indicates a trend, the price movement might already have started, which can delay entry and exit points.
- Inadequacy for range-bound markets: The MACD performs best in bullish or bearish trending markets. The MACD may produce more false signals in range-bound or sideways markets, leading to potential losses.
Unraveling the Complexities of MACD: A Wrap-Up
The Moving Average Convergence/Divergence (MACD) indicator assists in identifying market trends, gauging momentum, potential entry and exit points and detecting possible trend reversals through divergences. The MACD is versatile and can be used across different markets, including stocks, commodities, and forex.
However, like all trading indicators, it's not foolproof and can sometimes generate false signals or lag behind real-time market changes. It would be advisable to use the MACD with other indicators and analysis methods to maximize its effectiveness.
Frequently Asked Questions
What are histograms in MACD?
In MACD, histograms visually represent the difference between the MACD and signal lines. They give you a picture of the degree of divergence between these two lines, providing potentially valuable insights into the strength and direction of a market trend.
What color is the MACD signal line?
The color of the MACD signal line can vary depending on the charting software or platform you’re using. Typically, the MACD line is colored blue or red and the signal line is often depicted in a contrasting color like orange or green for clear differentiation.
What does it mean when the MACD is negative?
When the MACD is negative, the 12-day Exponential Moving Average (EMA) is below the 26-day EMA. This indicates a bearish market trend, suggesting it might not be the best time to buy.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.