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What Is Moving Average Convergence

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What Is Moving Average
Convergence/Divergence (MACD)?
Moving average convergence/divergence (MACD, or MAC-D)
is a trend-following momentum indicator that shows the
relationship between two exponential moving averages
(EMAs) of a security’s price. The MACD line is calculated by
subtracting the 26-period EMA from the 12-period EMA.
The result of that calculation is the MACD line. A nine-day
EMA of the MACD line is called the signal line, which is
then plotted on top of the MACD line, which can function
as a trigger for buy or sell signals. Traders may buy the
security when the MACD line crosses above the signal line
and sell—or short—the security when the MACD line
crosses below the signal line. MACD indicators can be
interpreted in several ways, but the more common
methods are crossovers, divergences, and rapid rises/falls.
KEY TAKEAWAYS

The moving average convergence/divergence (MACD,
or MAC-D) line is calculated by subtracting the 26period 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 default.

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.
MACD Formula
MACD=12-Period EMA − 26-Period EMAMACD=12-Period EMA − 26Period EMA
MACD is calculated by subtracting the long-term EMA (26
periods) from the short-term EMA (12 periods). An EMA is
a type of moving average (MA) that places a greater weight
and significance on the most recent data points.
The exponential moving average is also referred to as the
exponentially weighted moving average. An exponentially
weighted moving average reacts more significantly to
recent price changes than a simple moving average (SMA),
which applies an equal weight to all observations in the
period.
Learning from MACD
MACD has a positive value (shown as the blue line in the
lower chart) whenever the 12-period EMA (indicated by
the red line on the price chart) is above the 26-period
EMA (the blue line in the price chart) and a negative value
when the 12-period EMA is below the 26-period EMA. The
level of distance that MACD is above or below
its baseline indicates that the distance between the two
EMAs is growing.
In the following chart, you can see how the two EMAs
applied to the price chart correspond to the MACD (blue)
crossing above or below its baseline (red dashed) in the
indicator below the price chart.
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Learning from MACD
MACD has a positive value (shown as the blue line in the
lower chart) whenever the 12-period EMA (indicated by
the red line on the price chart) is above the 26-period
EMA (the blue line in the price chart) and a negative value
when the 12-period EMA is below the 26-period EMA. The
level of distance that MACD is above or below
its baseline indicates that the distance between the two
EMAs is growing.
In the following chart, you can see how the two EMAs
applied to the price chart correspond to the MACD (blue)
crossing above or below its baseline (red dashed) in the
indicator below the price chart.
----
MACD is often displayed with a histogram (see the chart
below) that graphs the distance between MACD and its
signal line. If MACD is above the signal line, the histogram
will be above the MACD’s baseline, or zero line. If MACD is
below its signal line, the histogram will be below the
MACD’s baseline. Traders use the MACD’s histogram to
identify when bullish or bearish momentum is high—and
possibly for overbought/oversold signals.
MACD vs. Relative Strength
The relative strength index (RSI) aims to signal whether a
market is considered to be overbought or oversold in
relation to recent price levels. The RSI is an oscillator that
calculates average price gains and losses over a given period
of time. The default time period is 14 periods with values
bounded from 0 to 100. A reading above 70 suggests an
overbought condition, while a reading below 30 is
considered oversold, with both potentially signaling a top is
forming, or vice versa (a bottom is forming).
The MACD lines, however, do not have concrete
overbought/oversold levels like the RSI and other oscillator
studies. Rather, they function on a relative basis. That’s to
say an investor or trader should focus on the level and
direction of the MACD/signal lines compared with
preceding price movements in the security at hand, as
shown below.
MACD measures the relationship between two EMAs, while
the RSI measures price change in relation to recent price
highs and lows. These two indicators are often used
together to give analysts a more complete technical picture
of a market.
These indicators both measure momentum in a market, but
because they measure different factors, they sometimes give
contrary indications. For example, the RSI may show a
reading above 70 (overbought) for a sustained period of
time, indicating a market is overextended to the buy side
in relation to recent prices, while the MACD indicates that
the market is still increasing in buying momentum. Either
indicator may signal an upcoming trend change by showing
divergence from price (price continues higher while the
indicator turns lower, or vice versa).
Limitations of MACD and Confirmation
One of the main problems with a moving average
divergence is that it can often signal a possible reversal, but
then no actual reversal happens—it produces a false
positive. The other problem is that divergence doesn’t
forecast all reversals. In other words, it predicts too many
reversals that don’t occur and not enough real price
reversals.
This suggests confirmation should be sought by trendfollowing indicators, such as the Directional Movement
Index (DMI) system and its key component, the Average
Directional Index (ADX). The ADX is designed to indicate
whether a trend is in place or not, with a reading above
25 indicating a trend is in place (in either direction) and a
reading below 20 suggesting no trend is in place.
Investors following MACD crossovers and divergences should
double-check with the ADX before making a trade on an
MACD signal. For example, while MACD may be showing a
bearish divergence, a check of the ADX may tell you that a
trend higher is in place—in which case you would avoid the
bearish MACD trade signal and wait to see how the market
develops over the next few days.
On the other hand, if MACD is showing a bearish crossover
and the ADX is in non-trending territory (<25) and has
likely shown a peak and reversal on its own, you could have
good cause to take the bearish trade.
Furthermore, false positive divergences often occur when
the price of an asset moves sideways in a consolidation,
such as in a range or triangle pattern following a trend. A
slowdown in the momentum—sideways movement or slow
trending movement—of the price will cause MACD to pull
away from its prior extremes and gravitate toward the
zero lines even in the absence of a true reversal. Again,
double-check the ADX to determine whether a trend is in
place and also look at what price is doing before acting.
Example of MACD Crossovers
As shown on the following chart, when MACD falls below
the signal line, it is a bearish signal indicating that it may
be time to sell. Conversely, when MACD rises above the
signal line, the signal is bullish, suggesting that the price of
the asset might experience upward momentum. Some
traders wait for a confirmed cross above the signal line
before entering a position to reduce the chances of being
faked out and entering a position too early.
Crossovers are more reliable when they conform to the
prevailing trend. If MACD crosses above its signal line after
a brief downside correction within a longer-term uptrend,
it qualifies as a bullish confirmation and the likely
continuation of the uptrend.
If MACD crosses below its signal line following a brief move
higher within a longer-term downtrend, traders would
consider that a bearish confirmation.
Example of Divergence
When MACD forms highs or lows that that exceed the
corresponding highs and lows on the price, it is called a
divergence. A bullish divergence appears when MACD forms
two rising lows that correspond with two falling lows on
the price. This is a valid bullish signal when the long-term
trend is still positive.
Some traders will look for bullish divergences even when
the long-term trend is negative because they can signal a
change in the trend, although this technique is less reliable.
When MACD forms a series of two falling highs that
correspond with two rising highs on the price, a bearish
divergence has been formed. A bearish divergence that
appears during a long-term bearish trend is considered
confirmation that the trend is likely to continue.
Some traders will watch for bearish divergences during
long-term bullish trends because they can signal weakness
in the trend. However, it is not as reliable as a bearish
divergence during a bearish trend.
Example of Rapid Rises or Falls
When MACD rises or falls rapidly (the shorter-term moving
average pulls away from the longer-term moving average),
it is a signal that the security is overbought or oversold and
will soon return to normal levels. Traders will often
combine this analysis with the RSI or other technical
indicators to verify overbought or oversold conditions.
It is not uncommon for investors to use the MACD’s
histogram the same way that they may use the MACD
itself. Positive or negative crossovers, divergences, and rapid
rises or falls can be identified on the histogram as well.
Some experience is needed before deciding which is best in
any given situation, because there are timing differences
between signals on the MACD and its histogram.
How do traders use moving average
convergence/divergence (MACD)?
Traders use MACD to identify changes in the direction or
strength of a stock’s price trend. MACD can seem
complicated at first glance because it relies on additional
statistical concepts such as the exponential moving average
(EMA). But fundamentally, MACD helps traders detect
when the recent momentum in a stock’s price may signal a
change in its underlying trend. This can help traders decide
when to enter, add to, or exit a position.
Is MACD a leading indicator or a lagging
indicator?
MACD is a lagging indicator. After all, all the data used in
MACD is based on the historical price action of the stock.
Because it is based on historical data, it must necessarily
lag the price. However, some traders use MACD histograms
to predict when a change in trend will occur. For these
traders, this aspect of MACD might be viewed as a leading
indicator of future trend changes.
What is a MACD bullish/bearish divergence?
A MACD positive (or bullish) divergence is a situation in
which MACD does not reach a new low, despite the fact
that the price of the stock has reached a new low. This is
seen as a bullish trading signal—hence, the term
“positive/bullish divergence.” If the opposite scenario
occurs—the stock price reaches a new high, but MACD fails
to do so—this would be seen as a bearish indicator and
termed “negative/bearish divergence.” In both cases, the
setups suggest that the move higher/lower will not last, so
it is important to look at other technical studies, like the
relative strength index (RSI) discussed above.
The Bottom Line
MACD is a valuable tool of the moving-average type, best
used with daily data. Just as a crossover of the nine- and
14-day SMAs may generate a trading signal for some
traders, a crossover of the MACD above or below its signal
line may also generate a directional signal.
MACD is based on EMAs (more weight is placed on the
most recent data), which means that it can react very
quickly to changes of direction in the current price move.
But that quickness can also be a two-edged sword.
Crossovers of MACD lines should be noted, but confirmation
should be sought from other technical signals, such as the
RSI, or perhaps a few candlestick price charts. Further,
because it is a lagging indicator, it argues that confirmation
in subsequent price action should develop before taking the
signal.
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