The trend-following momentum indicator known as moving average convergence divergence (MACD) displays the connection between two moving averages of the price of an asset. The 26-period exponential moving average (EMA) is subtracted from the 12-period EMA to generate the MACD.
The MACD line is the output of the calculation. The “signal line,” a nine-day EMA of the MACD that may be used to generate buy and sell signals, is then placed on the top of the MACD line. When the MACD crosses above its signal line, a trader may purchase the asset; when it crosses below, a trader may sell or short the security. There are various ways to interpret moving average convergence divergence (MACD) indications, but the most popular ones include crosses, divergences, and rapid increases and falls.
What is MACD?
The Moving Average Convergence/Divergence oscillator, created by Gerald Appel in the late 1970s, is one of the most straightforward and efficient momentum indicators. By deducting the longer moving average from the shorter ones, the MACD converts two trend-following indicators, or moving averages, into a momentum oscillator.
Thus, the MACD offers trend following and momentum, the best of both worlds. As the moving averages converge, intersect, and diverge, the MACD moves above and below the zero line. To produce signals, traders should watch for signal line crossovers, centerline crossovers, and divergences. The MACD is unbounded, which makes it less effective in spotting overbought and oversold levels.
Example of MACD (Source: StockCharts)
MACD VS. Relative Strength
According to current price levels, the relative strength index (RSI) seeks to indicate whether a market is seen to be overbought or oversold. The RSI oscillator determines the typical price gains and losses over a certain time frame. The 14-period default time period has values that range from 0 to 100.
While the RSI measures price movement with respect to recent price highs and lows, the MACD measures the connection between two EMAs. Combining these two indicators gives analysts a more thorough technical view of a market.
Both of these indicators assess market momentum, but because they assess several elements, they may provide conflicting results. For instance, the MACD may signal that the market is continuing to gain purchasing momentum, while the RSI may display a value over 70 for a long period of time, indicating that the market is overextended to the buy-side about recent levels. Any indication that deviates from price may indicate an impending trend shift (price continues higher while the indicator turns lower, or vice versa).
MACD Crossover Example
The following chart shows that the MACD dropped below the signal line as a bearish signal suggesting it could be time to sell.
In contrast, the MACD produces a positive signal when it crosses above the signal line, indicating that the asset’s price is expected to have upward momentum. To minimize the likelihood of getting “faked out” and taking a position too soon, some traders wait for a verified cross above the signal line before taking a position.
When crossovers follow the dominant trend, they are more trustworthy. Following a small pullback inside a longer-term rally, the MACD crossing above its signal line is considered positive confirmation.
Traders would view it as a negative confirmation if the MACD crossed below its signal line following a brief upward movement inside a longer-term downtrend.
Divergence Example
A divergence occurs when the MACD creates highs or lows that differ from the corresponding prices’ corresponding highs and lows.
A bullish divergence is created when the MACD creates two rising lows corresponding to two falling lows on the price. This is a reliable bullish indication of the long-term trend in favor. Even when the long-term trend is negative, some traders may seek positive divergences since they can indicate a shift in trend. However, this strategy is less accurate.
A bearish divergence has occurred when the MACD creates a series of two falling highs that coincide with two rising highs in the price. A long-term negative trend is confirmed to be likely to persist if a bearish divergence develops throughout the trend.
Some traders may keep an eye out for bearish divergences during long-term bullish trends since they can indicate trend weakness. It is less trustworthy than a bearish divergence during a negative trend.
Takeaways
- The trend-following momentum indicator known as moving average convergence divergence (MACD) displays the connection between two moving averages of the price of an asset.
- The relative strength indicator (RSI) indicates whether a market is seen as overbought or oversold.
- The most popular ways to interpret MACD include crosses, divergences, and rapid increases and falls.
- A bullish divergence is created when the MACD creates two rising lows corresponding to two falling lows on the price.
