The Moving Average Convergence / Divergence (MACD) is perhaps one of the most well recognised, simple and effective momentum and trend indicators. This indicators converts two exponential moving averages into a centred momentum oscillator by subtracting the longer-term moving average from the short-term moving average.
As mentioned above this is a centred oscillator, meaning that the MACD fluctuates above or below a centre line, in this case 0, as opposed to bounded readings such as the slow stochastic.
The calculation for this indicator is very simple:
MACD Line = 12-day EMA less 26-day EMA
Signal Line = 9-day EMA of MACD line
MACD Histogram = MACD line – Signal Line
This indicator serves to highlight the relationship between the two moving averages, whether they are converging or diverging. A convergence of the two moving averages is when they are coming together while a divergence is when they are moving further apart. The short-term moving average reacts faster than the longer-term moving average to changes in price, so when the short moving average is above the long moving average the MACD line is above 0 and momentum is up. The inverse is also true, when the short moving average is below the long moving average the MACD line is below 0 and momentum is negative.
This indicator uses exponential moving averages as opposed to simple moving averages of which the effect is heavier weighting towards more recent data meaning the moving average reacts faster to changes in price. While traditionally the periods of 12, 26 and 9 are used to calculate this, it can be adjusted to increase or decrease the sensitivity depending on the preference of the individual trader.
The first chart below shows CBA in the top pane, with a 12-period EMA in red and a 26-period EMA in blue. The bottom pane represents the MACD, with the MACD line shown in red, the signal line in blue and the MACD histogram.
Using this indicator we can generate multiple trading signals, the first is a signal line crossover. This is where the MACD line crosses up or below the signal line (9-day EMA of the MACD line) to generate buy or sell signals. A bullish cross is where the MACD line crosses up through the signal line generating a buy signal while a bearish cross is where the MACD line cross down through the signal line generating a sell signal. Prior to this crossover we can see the MACD histogram decreasing, signalling the MACD line and signal line are beginning to converge and a potential warning a sell signal may be around the corner.
Using the same CBA chart above, we can see on the 15th of October the MACD line crosses up through the signal line generating a buy signal, which is also visually represented by the MACD histogram showing a positive reading of +0.04. Next we can see a sell signal is generated on the 17th of November when the MACD line crosses down through the signal line, at which point the trader would exit the position.
Next we can use crosses up or down through the centre line (0) to generate buy and sell signals or confirmation signals similar to the average directional index. A bullish cross is where the MACD line crosses up above 0, indicating that the short-term moving average is now above the longer-moving average meaning momentum is now positive. Inversely when the MACD line crosses below 0 momentum turns negative as the short moving average is now below the longer moving average.
On the same chart again we can see that momentum turns positive acting as a confirmation signal for the previous bullish signal line crossover on the 15th of October when the MACD line crosses up above the 0 centre line on the 27th of October, highlighting that the 12-period EMA has is now above the 26-period EMA.
Finally, similar to other oscillators such as the RSI and stochastics we can use the MACD line to identify divergences. A divergence is when the MACD line and price of the underlying security diverge, signalling a potential reversal. Bullish momentum divergence is formed when the price moves to a new low while the MACD line forms a higher level signalling the potential reversal of a downtrend. Conversely bearish momentum divergence forms when the price moves to a new high while the MACD line forms a lower high, signalling the potential reversal of.
Using CBA once more we can see the formation of bearish momentum divergence between the February 6th high at $93.45 and the March 23rd high at $96.16. Clearly the price moves to a new high however the MACD line shown in red on the bottom pane forms a lower high, highlighting that the gap between the 12 & 26-period EMA’s is narrower at the March high than it was in February. This signals that the strength of the trend is fading and susceptible to a potential reversal, which we can see from late March to early June when the price falls steadily. This is then followed by clear bullish momentum divergence between the May 5th low at $80.56 and the June 10th low of $78.76, where the MACD forms a higher low signalling the strength of declines is fading and at risk of a reversal which then occurs as the price moves higher to $88.40 on the 21st of July.
Overall the MACD is very useful to identify momentum or trends, trading signals and divergences. However as it fluctuates around a centre line it is not effective at identifying over or under bought signals as in theory it is boundless, although you could compare levels with historical levels. The other limitation of this indicator is that there is a lag effect given it uses moving averages, therefore this indicator is useful as a confirmation indicator rather than a predictor. As always this indicator should be used with further analysis to confirm signals.
