MACD (Moving Average Convergence/Divergence) is a very simple, easy and trustworthy technical indicator that is known to yield consistent results in spotting profitable trades. It is recommended that before you begin reading this feature, do quickly go through our feature on Moving Averages to recall the basics.
The MACD works with EMAs (Exponential Moving Averages) and is calculated by deducting the longer EMA from the shorter EMA and then benchmarking the derived MACD curve with a trigger line to help traders make a trading call. Sounds confusing? Well, it isn’t – it’s very simple and here is how it’s done.
The standard and the most popular MACD formula
The MACD value for a given day is calculated using the following standard formula, employed by most technical analysis software programs:
MACD = 12-Day EMA – 26-Day EMA
It can be deduced from this equation that if a 12-day EMA is greater than a 26-day EMA then MACD will have a positive value, and if vice versa then MACD will have a negative value. The EMA values used here are those calculated using the closing price for that day. Each MACD value calculated from this equation yields one data point on the MACD curve. The various MACD data points calculated for different days are joined and the resultant curve is compared with a trigger curve, which is usually a 9-day EMA curve. If the MACD curve crosses the 9-day EMA curve, it signals a bullish trend; when it falls below it, a bearish signal emerges.
Figure 1 illustrates how a profitable trade signal is given out using the MACD curve. Remember this: your job is to understand the concept, and not to calculate the EMAs and the MACD curve – these calculations are performed by standard software:
The 26-day, 12-day and 9-day EMAs are part of a standard, popular formula. Many top technical analysts tinker around with the numbers of days used to calculate the MACD curve and the trigger line, and arrive at other MACD values that too can help spot profitable trades for day- and short-term traders, as well as for long-term players.
MACD – Implications
Here are some implications of the MACD indicator:
1. When the 12-day EMA exceeds the 26-day EMA, the MACD is positive. This is a bullish signal.
2. When the gap between the 12-day EMA and the 26-day EMA widens in the upward direction, it indicates that the stock is getting stronger and is likely to head into a new upward price zone.
3. When the 26-day EMA exceeds the 12-day EMA, the MACD is negative. This gives a bearish signal.
4. When the gap between the 12-day EMA and the 26-day EMA widens in the downward direction, it indicates that the stock is getting weaker and is likely to head into a new lower price zone.
MACD – Buy signals
1. The most reliable buy signal given out by MACD is when the stock’s price is in a downtrend but the MACD curve begins to move forward, creating successively higher lows. It doesn’t matter if the stock is in a downtrend.
This signal is called “Positive Divergence” in technical analysis jargon, but don’t let names and terms bother you so long you understand the concept. These signals are not common, but you have to watch for them. Once the MACD gives this type of signal, you can be rest assured that the stock will fly upwards. Figure 42 shows an example of such a signal:
2. Many technical analysts sound a buy call when the MACD curve moves above the trigger line. But this event (MACD moving above the trigger line) is not a reliable indicator and you must not follow it unless and until other technical indicators confirm an up-trend. The MACD tends to swing above and below the trigger line frequently and too much must not be read into it.
3. When the MACD curve begins moving up from negative territory (where it had stayed for a considerable length of time) and crosses the “Zero Line” (the line in the chart represented by “0” MACD value), then it is a buy signal, especially if it is confirmed by either (2) or (1) above. This is also called “Bullish Centerline Crossover”. Figure 3 illustrates how this works:
MACD – Sell signals
1. The most reliable “sell” signal given out by MACD is when the stock’s price is moving sideways or in an up-trend but the MACD curve begins to move downward, creating successively lower highs.
This signal is called “Negative Divergence” in technical analysis jargon. These signals are not common, but once the MACD gives this signal, you can be rest assured that the stock will crash. Figure 4 shows an example of such a signal.:
2. When the MACD curve moves below the trigger line, many amateur technical analysts rush to sell, but this event (MACD moving below the trigger line) is not a reliable indicator.
3. When the MACD curve begins moving down from positive territory (where it had stayed for a considerable length of time) and falls below the “Zero Line” (the line in the chart represented by “0” MACD value), then it is a sell signal, especially if it is confirmed by either (2) or (1) above. This is also called “Bearish Centerline Crossover”. Figure 5 illustrates how it works:
The good and the bad of MACD
Here’s the good news:
1. The MACD works – this has been proven time and again.
2. It is an excellent momentum indicator and works very well for day- and short-term traders.
3. It works effectively even for medium–long-term traders. Instead of the 12-day and 26-day EMAs, longer-period (30, 45, 60, 90, 100 and even 200 day) averages are compared to determine trends. Here’s a nifty tip: apply longer-term EMAs to volatile stocks and shorter-term EMAs to relatively stable stocks.
That was the good news, now here are the bad sides of MACD:
1. MACD cannot be used to figure out overbought/oversold levels.
2. When a stock moves up considerably over a period of time, there is no point using MACDs on historical data. For example, when a stock moves from GBP 1 to GBP 10 in 3 months and stays around the higher price, then long-term MACD becomes difficult to interpret.
MACD works, and it has stood the test of time. It is simple, easy and reliable, and you should use it to determine trends. Just remember to adjust the time periods – for example, if you are a short-term or day trader than the current configuration of 26, 12, 9 days works well; if you are a medium-term player, adjust the number of days. Finally, if a stock has moved up considerably, then use only short-term MACD to determine its trend.