The Moving Average Convergence/Divergence indicator is a momentum oscillator primarily used to trade trends. Although it is an oscillator, it is not typically used to identify over bought or oversold conditions. It appears on the chart as two lines which oscillate without boundaries. The crossover of the two lines give trading signals similar to a two moving average system.
When the MACD line crosses from below to above the signal line, the indicator is considered bullish. The further below the zero line the stronger the signal. When the MACD line crosses from above to below the signal line, the indicator is considered bearish. The further above the zero line the stronger the signal.
There is a common misconception when it comes to the lines of the MACD.
There are two lines:
- The “MACD Line“
- The “Signal Line“
- The moving average convergence/divergence (MACD, or MAC-D) line is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The signal line is a nine-period EMA of the MACD line.
- MACD is best used with daily periods, where the traditional settings of 26/12/9 days is the norm.
- MACD triggers technical signals when the MACD line crosses above the signal line (to buy) or falls below it (to sell).
- MACD can help gauge whether a security is overbought or oversold, alerting traders to the strength of a directional move, and warning of a potential price reversal.
- MACD can also alert investors to bullish/bearish divergences (e.g., when a new high in price is not confirmed by a new high in MACD, and vice versa), suggesting a potential failure and reversal.
- After a signal line crossover, it is recommended to wait for three or four days to confirm that it is not a false move.
THE BASICS OF THE MACD INDICATOR
The MACD is based on moving averages ad this means that it’s ideal for analyzing momentum, finding trend-following entries, and staying in trends until momentum is dying off.
There are two MACD signals in particular that we will explore in this article and explain step by step how to use the MACD to find trades:
1) The MACD Line cross at 0
The screenshot below shows the MACD line and the Signal line at the bottom of the chart. I also plotted the two moving averages (12 and 26 EMA)on the charts.
This helps us understand the mechanism of the MACD right away:
When the two EMAs cross at the price chart, the MACD line crosses below 0 as well – I marked the cross with an x and a vertical line.
We can see that the MACD is identical to a regular moving average crossover system.
As we know from our moving averages article, a cross of two Moving Averages shows a change in momentum and it can often foreshadow the start of a new trend.
When the MACD Line crosses 0, it shows that momentum is changing and potentially a new trend might be starting.
2) The space between the MACD
When the two MACD indicator lines separate, it means that momentum is increasing and the trend is getting stronger.
When the two MACD lines are coming closer together, it shows that the price is losing strength.
Furthermore, we can use the 0-line as a trend tiebreaker. When the two MACD lines are above the 0-line, the price can be considered in an uptrend. And when the two MACD lines are below the 0-line, the price is in a downtrend.
Calculation
An approximated MACD can be calculated by subtracting the value of a 26 period Exponential Moving Average (EMA) from a 12 period EMA. The shorter EMA is constantly converging toward, and diverging away from, the longer EMA. This causes MACD to oscillate around the zero level. A signal line is created with a 9 period EMA of the MACD line.
Note: The sample calculation above is the default. You can adjust the parameters based upon your own criteria.
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