MACD indicator, meaning and how it works in trading

Identifying changes in the movement of asset prices is an important aspect of trading. Momentum plays an important role in stock market movements and for investors, it can significantly influence return potential. Hence, catching momentum changes on time is important, especially for investors who follow momentum trading strategies. The MACD, short for moving average convergence/divergence, is a tool that can help you here.

Read on for an in-depth look at how the MACD works and how traders can effectively use it in their trading.

• Table of contents

1. What is MACD?
2. How does MACD help traders?
3. The working of MACD
4. MACD components
5. How MACD is calculated
6. Reading MACD
7. MACD interpretations
8. How do traders use moving average convergence/divergence (MACD)?
9. Differences between MACD and relative strength index

What is MACD?

The MACD is a technical indicator used by traders to determine when the short-term momentum is changing in an asset. It is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The result from that calculation is the MACD line.

A 9-period EMA of the MACD line, known as the signal line, is then plotted above the MACD line. The interaction between the MACD line and the signal line is used to generate buy and sell signals. When the MACD line crosses above the signal line, it may indicate a buy signal, and when it crosses below, it could suggest a sell signal.

How does MACD help traders?

The MACD helps traders solve two main problems in trading: identifying trend changes and timing entries/exits.

Firstly, crossovers between the MACD line and signal line indicate that the momentum is shifting from bullish to bearish or vice versa, signaling a trend change.

Secondly, traders use the MACD histogram to identify divergences with price that show an asset is overextended and likely to reverse direction.

The working of MACD

The MACD is calculated from two exponential moving averages (EMAs). The standard MACD uses the following three parameters.

• 12-period EMA – This EMA captures short-term price momentum. A shorter EMA responds more quickly to price changes compared to a longer EMA.
• 26-period EMA – This EMA captures longer-term price momentum. The 26-period EMA responds more slowly than the 12-period EMA.
• Signal line (9-period EMA of MACD) – This line trails the MACD and functions as a trigger line for buy/sell signals.

MACD components

The MACD indicator has three components.

• MACD line: The difference between the 12 and 26-period EMAs. The MACD line reflects changes in the momentum of asset prices.
• Signal line: The 9-period EMA of the MACD line. The signal line trails the MACD line and functions as a trigger for buy/sell signals.
• MACD histogram: The difference between the MACD line and signal line. The histogram oscillates above/below the zero line, visualising increasing or decreasing momentum. It helps traders quickly spot shifts in momentum.

How MACD is calculated

The steps to calculate the MACD are below.

1. Calculate the 12-period EMA from the asset's closing prices.
2. Calculate the 26-period EMA from the asset's closing prices.
3. Subtract the 26-period EMA from the 12-period EMA to get the MACD line.
4. Calculate a 9-period EMA of the MACD line to get the signal line.
5. Subtract the signal line from the MACD line to get the MACD histogram.

Reading MACD

There are three primary ways traders analyse the MACD to generate trading signals.

• Crossovers: When the MACD line crosses above the signal line, it is a buy signal as upside momentum is increasing. When the MACD line crosses below the signal line, it is a sell signal as downside momentum is increasing.
• Divergences: When the MACD forms higher highs/lower lows than price, it signals an impending reversal as momentum is not confirming the price trend. Traders act when price eventually moves in the direction of the MACD divergence.
• Histogram: Traders also look for a change in the MACD histogram from positive to negative (or vice versa) to signal a shift in momentum, especially when combined with a crossover.

MACD interpretations

• Positive MACD: Upside momentum is increasing as the faster EMA pulls away from the slower EMA. Bullish signal.
• Negative MACD: Downside momentum is increasing as the faster EMA pulls towards the slower EMA. Bearish signal.
• MACD above signal line: Bullish as faster shorter-term momentum is leading the slower longer-term momentum.
• MACD below signal line: Bearish as slower longer-term momentum is leading the faster shorter-term momentum.
• Rising MACD: Momentum is accelerating to the upside. Bullish signal.
• Falling MACD: Momentum is accelerating to the downside. Bearish signal.
• MACD divergence: Price and momentum are moving in opposite directions, signaling a trend reversal.

How do traders use moving average convergence/divergence (MACD)?

• Trend identification: MACD crossovers can be used to identify when a new trend is forming. A bullish crossover signals upside momentum is building and a potential uptrend emerging. A bearish crossover signals downside momentum is building and a potential downtrend emerging.
• Trade entry/exit: Traders use MACD crossovers for trade entry and exit timing. A bullish crossover can trigger a long position, while a bearish crossover can trigger closing out a long and opening a short position. Traders may add to positions as the MACD trends in the direction of the trade.
• Divergence trades: Traders look for bullish/bearish divergences to signal an impending trend reversal and early entry. For example, they go long when the MACD forms higher lows as price makes lower lows after a downtrend.
• Filter for other strategies: Some traders will filter trading signals from other strategies by requiring confirmation from the MACD before taking a trade. This helps avoid false signals and reduce whipsaws.

Differences between MACD and relative strength index

MACD and Relative Strength Index (RSI) are both momentum oscillators used to identify overbought/oversold conditions and trend changes. The key differences between the two indicators are below.

• The MACD uses moving averages and shows momentum changes, while RSI uses internal price strength and overbought/oversold levels.
• The MACD is better for gauging trend direction and strength. The RSI is better for identifying overextended price moves and divergence setups.
• The MACD utilises crossovers and divergences, while the RSI uses breaking above/below the 70/30 lines for signals.
• The MACD oscillates above/below a zero line, while RSI oscillates between 0 and 100.
• The MACD works across various timeframes, while the RSI works best on shorter timeframes for identifying overbought/oversold levels.
• The MACD is more useful in trending markets, while the RSI can be advantageous in ranging markets.

Conclusion

The MACD is one of the most versatile technical indicators for traders. It condenses price action into an easy-to-read momentum oscillator that identifies changes in trend direction and momentum. MACD crossovers, divergences, and histogram analysis provide traders with high-probability trading signals. While no single indicator can identify all trading opportunities, the MACD is an invaluable tool that––when combined with other analysis––can significantly improve trading performance. Traders should incorporate the MACD into their overall trading strategy to take advantage of this useful indicator and better time entries and exits in the market.

Read Also: Technical analysis in mutual fund investing: A guide for flexi cap funds

Read Also: A comprehensive guide to understanding and using the relative strength index (RSI)

FAQs:

What is MACD in stock market?

The MACD (Moving Average Convergence Divergence) is a technical indicator that helps identify trends, potential reversals, and entry points for buying or selling by analysing the relationship between these moving averages.

What is MACD indicator?

The MACD indicator is a trend-following momentum tool that calculates the difference between a short-term EMA (usually 12 days) and a long-term EMA (usually 26 days) of a security's price.

What does the MACD have to say to you?

The MACD provides insights into market trends and momentum, helping you identify potential buy or sell signals based on crossovers between the MACD line and the signal line. It also highlights divergences between the MACD and the stock price, which can indicate weakening trends or potential reversals.

Is the MACD a reliable indicator?

While the MACD is a widely used and reliable indicator for identifying trends and momentum shifts, it is not infallible, particularly in sideways markets. Its reliability can be enhanced by combining it with other technical indicators and by fine-tuning its settings to match specific market conditions.

Is MACD used by professional traders?

Yes, the MACD is commonly used by professional traders due to its simplicity and effectiveness in identifying trend reversals and momentum changes. It is often combined with other technical tools to provide a more comprehensive view of market conditions and to confirm trading signals.

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