Moving Average Convergence Divergence (MACD) – Explained for Dummies

What is a moving average (MA)?

A moving average is an indicator in technical analysis that describes the average price of a security over a specified period of time, indicating the direction of a trend.

By using the MA, the impacts of inconsistent, short-term fluctuations on the price of a security over a certain time period are reduced.

It is referred to as a ‘moving’ average because it is frequently recalculated based on the latest price data.

MA indicators are commonly used in technical analysis.

What is the difference between a simple moving average and an exponential moving average?

A simple moving average (SMA) is calculated by adding a security’s closing prices over a certain number of time periods and dividing the sum obtained by the same number of time periods to determine an average. Put differently, an SMA is the average price of a security over a specific period of time.

An exponential moving average (EMA) is a weighted moving average that is calculated in the same way as an SMA. However, it gives more weight to recent price data.

What is a moving average convergence divergence (MACD)?

Moving Average Convergence Divergence (MACD) is a momentum technical indicator that shows the relationship between two exponential moving averages of the price of a security, indicating a new trend, either bullish or bearish.

Convergence implies that two moving averages are getting together, while divergence indicates that they are turning away from each other.

Elements of the MACD indicator

The MACD indicator comprises 3 elements:

• The MACD line, which determines the distance between two moving averages.

The formula to create the MACD line is: 12-period exponential moving average (EMA) minus 26-period exponential moving average (EMA).

The MACD line is the faster moving average, moving generally above and below the signal line.

• The signal line, which signals changes in price movement, activating buy and sell signals.

The signal line is a 9-period exponential moving average.

Since it is a slower moving average than the MACD line, it is frequently breached by the MACD line.

• The histogram, which is a graphical representation of the distance between the MACD line and the signal line. The bigger the difference between the two lines, the higher the bars that are displayed in the histogram.

When the MACD line is above the signal line, the histogram will be positive. Conversely, the histogram will show a negative value when the MACD line moves below the signal line.

Keep in mind, the MACD line and the signal line are the moving averages of the difference between two moving averages. They do not represent moving averages of the price.

How to interpret the MACD indicator

The MACD measures momentum by utilising the MACD line and zero line, also known as base line, as reference points. The MACD line and signal line fluctuate in and around the zero line, indicating overbought and oversold signals above and below the base line, respectively.

Trading signals indicated by the MACD:

• When the MACD line moves above the base line, it signals an uptrend.
• When the MACD line dips below the zero line, it indicates a downtrend.
• When the MACD line crosses above the signal line, it is an indication for traders to buy. This crossover is also referred to as a bullish MACD crossover, implying that price might start to increase.
• When the MACD line moves below the signal line, it is called a bearish MACD crossover, hinting that prices might start to decline. Typically, traders use it as an indication to sell.
• A bullish MACD divergence takes place when the price action is trending downwards and the MACD line is indicating higher bottoms, giving a strong bullish signal. Usually, a price starts a strong upward movement after a bullish MACD divergence.
• A bearish MACD divergence occurs when the price is rising and the MACD line is creating lower tops, suggesting that the price might move in a bearish direction. Often, a quick bearish move will follow a bearish MACD divergence.
• It is an overbought MACD when the MACD line moves a relatively big distance from the signal line. The expectation is that the bullish trend will start to dwindle after the strong increase followed by a bearish trend.
• The oversold MACD signal occurs when the MACD line secures a relatively significant distance from the signal line. The price is expected to stop decreasing and start increasing.

Pros of the MACD

• The MACD indicator is one of the most widely used technical indicators in trading because it is both simple and reliable.
• It provides two different signals: the strength of buy and sell signals and whether a trend is moving upwards or downwards.

Cons of the MACD

• Although useful for trading, the MACD is not very efficient without other technical indicators, such as the relative strength index (RSI).
• The MACD is a short-term indicator with its longest measurement the 26-day moving average. Hence, the MACD may not be suitable for a trader who has a longer-term outlook.
• The MACD is an indicator that follows trends, signalling a trend as it occurs, not before it starts. Therefore, it is not effective to identify an upcoming trend.
• Divergence can often signal a possible reversal but then no actual reversal happens, creating a false positive.
• Furthermore, divergence does not predict all reversals. Put differently, divergence forecasts too many reversals that eventually do not take place and not enough genuine price reversals.
• Generally, the MACD indicator is regarded to be efficient in trending markets, limiting its use in consolidating markets that will generally provide flawed signals when using the MACD.

Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.