The Moving Average Convergence Divergence (MACD, in short) is a popular and powerful technical analysis tool used by traders and investors to identify potential trend reversals and momentum changes, providing buy or sell signals in financial markets. Developed by Gerald Appel in the late 1970s, MACD has become a staple in the toolkit of technical analysts worldwide due to its simple yet effective usage.
What is MACD?
MACD is a trend-following indicator that utilizes exponential moving averages (EMA). In addition to tracking trends, it also assists traders in assessing momentum. By combining these two features, it provides traders with an easy tool to swiftly gauge the market’s direction and potential trend changes. There are different components of MACD that can be utilized in various ways.
- MACD Line: This line represents the difference between the 12-day and 26-day exponential moving averages. The rationale behind this is that the shorter-term moving average responds more quickly to price changes, while the longer one moves more slowly. A change in the direction of this difference indicates a shift in momentum and a potential trend change.
- Signal Line: Since the MACD line is constantly changing, the 9-day EMA of the MACD line can be employed as a signal line. Similar to moving average crossovers, when the MACD and signal line intersect, it generates buy or sell signals.
- Histogram: The histogram illustrates the difference between MACD and the signal line. This provides insights into the strength of the trend and identifies overly rapid market movements that may be corrected later.
MACD can be utilized in various ways depending on the preferences of individual traders. Some of the most common and effective applications include:
Crossover Signals
MACD crossing the signal line is seen as a “buy signal,” while crossing it below is seen as a “sell signal.” Although it usually provides relatively good signals, the extra smoothing inherent in MACD crossovers often results in delayed signals, potentially leading to poor decisions in a whipsaw market with long candlesticks. However, in most cases, it can serve as a valuable addition to technical charts, especially for longer timeframes featuring clear trends or wide flat rectangles. Depending on the history of trends and the size of candlesticks during sudden changes, it can be advisable to occasionally adjust the periods of the EMAs to find a balance that better suits the chart’s characteristics.
Zero Line Cross
With clearer trends in place, signal crossovers might generate too many signals, potentially resulting in lower profits compared to a “buy and hold” strategy and incurring additional costs in commissions. If fundamentals support significant trends, such as after major shocks like the COVID-19 crash or during rate-hiking and cutting cycles, traders might prefer to hold positions for longer durations. To control the risk of an immediate trend change, MACD and zero-level crossovers can be employed. MACD, being the difference of two moving averages, essentially means following moving average crossovers.
Sometimes, during extended trends, there may be aggressive testing of the trend. During such times, zero crossovers can result in multiple losses in a row, resembling a choppy zone. However, this is often seen as the cost of managing risks because if the trend changes abruptly with a few long candlesticks, months of profit can dissipate in a matter of days.
Divergence
Similar to many oscillators, MACD can be used to identify divergences. At the end of trends, indicators like RSI and MACD often provide divergence warnings. These warnings, like those of many indicators, are not always reliable, but when used in conjunction with other technical tools, their reliability can be improved for better trading results.
During downtrends, while prices are making lower lows and lower highs, if MACD forms higher lows, this could be seen as a positive divergence, signaling a potential weakening of the downtrend. These higher lows can occur two, three, or in rare cases, four times, making the exact moment to enter a trade tricky. For a safer approach, waiting for a trendline breakout or using an appropriate horizontal stop to limit losses might lead to better results.
In contrast to positive divergence, when prices are making higher highs and higher lows, if MACD forms lower highs, this is called negative divergence. Just like positive divergence, negative divergence serves as a warning of a potential weakening of the trend.
Histogram
Using the histogram of MACD is not the most popular method, but it often provides valuable warnings during significant market moves. The drawback is that it can be highly subjective, requiring some practice to find the right approach and determine suitable levels for each chart. Another weakness is that the histogram does not offer clear signals for entry or exit; instead, it mainly warns about market extremism and potential early market correction.
In the example above, we observe the weekly gold chart. Points at 18 and negative 18 often mark the end points of the histogram, making their use appear appropriate. High or low histogram points suggest that the MACD line is moving away from the signal line too rapidly. Typically, when prices move aggressively in one direction, charts tend to correct themselves through a “return to averages” mechanism. As seen in the example, nearly every time the MACD reaches or returns from higher levels to 18, gold experiences a small negative reaction or a shift toward a negative trend change begins. Similarly, at the positive side, negative 18 corresponds well to near dips.
When employing the MACD histogram in this manner, it is crucial to identify numerous previous examples for the current security and conduct a small test to determine if the chart has consistently provided reliable signals. Not all charts generate signals reliable enough to warrant trades, so it is important not to force trades based on poor signals.
