What is the MACD indicator?
Moving average convergence divergence (MACD) is a trend indicator that depicts the connection between two EMAs of a security's price. By deducting the 26-period EMA from the 12-period EMA, the MACD line is calculated.
The MACD line will be the outcome of the computation. The signal line is a nine-day EMA of the MACD line placed on top of the MACD line and may operate as a trigger for buy or sell signals. Traders may purchase the security when the MACD line crosses above the signal line and sell it when it crosses below the signal line. MACD indicators may be read in various ways, but the most typical include crosses, divergences, and quick rises/falls.
Calculation of MACD indicator
MACD = 12-Period EMA – 26-Period EMA
MACD is determined by taking the long-term EMA, 26 periods, and deducting it from the short-term EMA (12 times). An EMA is a KIND of moving average (MA) that gives the most recent data points more weight and relevance.
The exponentially weighted moving average is another name for the exponential moving average. An exponentially weighted moving average (EWMA) responds to current price fluctuations more strongly than a simple moving average (SMA), giving equal weight to all periodic assessments.
Interpreting MACD indicator
The MACD, as the name indicates, is concerned with the convergence and divergence of two moving averages. Convergence happens when the moving averages move in the same direction. Divergence happens when the moving averages begin to drift apart. The shorter moving average (12-day) is quicker and accounts for most MACD fluctuations. The long-term moving average (26-day) is slower and less responsive to the actual stock price fluctuations.
The MACD line shifts between being above and below the zero or center lines. These crossings indicate that the 12-day moving average has crossed the 26-day moving average. Of course, the direction is determined by the moving average cross. Positive MACD means that the 12-day EMA is higher than the 26-day EMA. As the shorter EMA diverges more from the longer EMA, positive values grow. This indicates that the upward momentum is rising. Negative MACD readings show that the 12-day EMA is lower than the 26-day EMA. Negative values grow as the shorter EMA diverges more below the longer EMA. This indicates that the downward momentum is intensifying.
Understanding MACD indicator
When the 12-period EMA is above the 26-period EMA, MACD depicts a positive value, and when the 12-period EMA is below the 26-period EMA, it signifies a negative value. The degree to which MACD is above or below its baseline shows that the gap between the two EMAs is expanding.
MACD is often accompanied or illustrated with a histogram, which tracks the distance between MACD and its signal line. If the MACD is higher than the signal line, the histogram will be higher than the MACD's baseline or zero line. The histogram will be under the MACD's zero line if the MACD is below its signal line. Investors use the MACD's histogram to determine the value of bullish or bearish momentum and potentially overbought/oversold.
Relative Strength vs. MACD indicator
The relative strength index (RSI) attempts to indicate whether a market is overbought or oversold with respect to current price levels. The RSI is an oscillator that computes the average price gain and loss over a particular period. The period is set to 14 by default, with values ranging from 0 to 100. A value over 70 indicates an overbought situation, while a reading below 30 indicates an oversold state, with both possibly predicting the formation of a peak or a bottom.
However, unlike the RSI and other oscillator studies, the MACD lines do not have specific overbought/oversold values. Instead, they operate on a relative scale. That is, an investor or stakeholder should pay attention to the level and direction of the MACD/signal lines in relation to previous price moves in the asset at hand. The MACD evaluates the connection between two exponential moving averages (EMAs), while the RSI monitors price fluctuations with respect to current price highs and lows. These two indicators are often employed in tandem to provide analysts with a full technical picture of an economy.
These indicators indicate market momentum, but since they measure distinct parameters, they may occasionally offer contradictory results. For example, the RSI may display a value over 70, depicting overbought for a lengthy period, suggesting that the market is biased on the buy side in reference to current prices. Yet, the MACD suggests that the market's purchasing momentum is still building. Any of the indicators may indicate an impending trend shift by diverging from price (the price continues to rise while the indicator falls, or vice versa).
MACD and Confirmation Limitations
One of the primary issues with moving average divergence is that it may often predict a prospective reversal but then fails to create an actual reversal. It thus provides a false positive. Another issue is that divergence does not predict all reversals. In other words, it forecasts too many false reversals and insufficient actual price reversals.
This implies that trend-following indicators, such as the Directional Movement Index (DMI) system and its essential component, the Average Directional Index (ADX), should be used to seek confirmation. The ADX is intended to identify whether a trend exists, with a number over 25 indicating a trend (in either direction) and a reading below 20 indicating no trend.
Investors monitoring for MACD crosses and divergences should double-check with the ADX before entering a trade based on a MACD signal. For instance, although the MACD may indicate a negative divergence, a look at the ADX may indicate that a trend upward is in place. In this case, you would disregard the bearish MACD trade indicator and watch how the market develops over the following few days.
On the other hand, if the MACD indicates a bearish crossing and the ADX is in a non-trending area that is less than 25, indicating a peak and reversal on its own, you may have a solid reason to enter the bearish trade.
Furthermore, false positive divergences are common when a security's price goes sideways in a consolidation, such as a range or a triangle pattern that follows a trend. Even without an apparent reversal, slowing price momentum (sideways or sluggish trending movement) can lead MACD to drift away from its past extremes and migrate toward the zero lines. Before acting, double-check the ADX and if a trend is in place.
Types of MACD crossovers
Crossovers are more dependable when they follow the current trend. Suppose the MACD rises above its signal line after a minor negative correction inside a longer-term uptrend. In that case, it is considered a positive confirmation and indicates that the uptrend is likely to continue. Traders will interpret this as bearish confirmation if the MACD crosses below its signal line after a brief rise within a longer-term downtrend.
- Single line crossovers. The most typical MACD signals are signal line crossovers. The signal line is the MACD line's 9-day EMA. It follows the MACD as a moving average of the indicator, making it more straightforward to notice MACD shifts. We have a bullish crossing when the MACD rises and crosses over the signal line. We get a bearish crossing when the MACD falls and crosses below the signal line. Depending on the power of the exercise, crossovers might endure a few days or weeks. Before depending on these usual indications, exercise caution. Crossovers of signal lines at positive or negative extremes should be approached carefully. Even though the MACD has no upper and lower bounds, chartists can estimate historical extremes. Even though the MACD has no upper and lower extremities, chart analysts can estimate the past extremes with a simple visual examination. The asset must make a big move to push momentum to an extreme.
- Centerline crossovers. The subsequent most prevalent MACD indications are centerline crossovers. When the MACD line rises above the baseline and becomes positive, this is referred to be a bullish centerline crossing. This occurs when the actual 's 12-day EMA crosses over the 26-day EMA. A bearish centerline crossing happens when the MACD falls below the zero line and begins to fall. When the 12-day EMA falls below the 26-day EMA, this occurs. Contingent on the trend's momentum, centerline crossings might last just a couple of days or several months. As long as there is a continuous upswing, the MACD will continue to be positive. When there is a persistent decline, the MACD will stay negative.
Instances of divergence
A divergence occurs when MACD generates highs or lows that surpass the matching maximum or minimum levels on the price. When MACD makes two rising lows that match two falling lows on the price, a positive divergence occurs. When a prospective trend remains positive, this is a reliable bullish indication.
Although this strategy is less dependable, some investors may seek bullish divergences irrespective of whether the long-term trend is negative since they might herald a shift. A bearish divergence is generated when MACD establishes a sequence of two falling highs that match two rising highs on the price. A bearish divergence sthat occurs during a long-term bearish trend indicates that the current pattern will likely persist.
Instances of a rapid rise or fall
When MACD quickly rises or falls (the more immediate moving average moves far from the longer-term moving average), the asset has been overbought or oversold and will shortly revert to its baseline levels. Investors often use this research with RSI or other technical indicators to confirm overbought or oversold positions.
Some investors may look for negative divergences during long-term bullish trends since they might indicate trend weakness. It is not, however, as trustworthy as a bearish divergence during a negative trend. Investors often utilize the MACD's histogram in the same manner as they use the MACD. Both beneficial and detrimental crossings, divergences, quick climbs, and dips may all be seen on the histogram. Because there are temporal disparities amongst indicators on the MACD and its histogram, some expertise is required before selecting which is better in any particular case.
Conclusion
MACD is a powerful moving-average method that works well with daily data. Crossing the MACD over or below the trend line may also provide a directional signal for confident investors, much as a crossover of the nine- and 14-day SMAs may.
Because MACD is based on EMAs (greater weight is given to the most current data), it may respond extremely fast to changes in trend in the current price action. However, rapidity may be a double-edged sword. Crossovers of MACD levels should be observed, but verification should come from other technical indicators, such as the RSI or a few candlestick price graphs. Furthermore, since it is considered a lagging indicator, it contends that future price fluctuations should be confirmed before adopting the signal.