20. (MACD) Moving Average Convergence Divergence

(MACD) Moving Average Convergence Divergence

The MACD indicator is one of the most popular technical analysis tools. MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it's bullish or bearish. After all, our top priority in trading is being able to find a trend, because that is where the most money is made.

There are three main components of the MACD shown in the picture below:

1. MACD: The 12-period exponential moving average (EMA) minus the 26-period EMA.
2. MACD Signal Line: A 9-period EMA of the MACD. 
3. MACD Histogram: The MACD minus the MACD Signal Line.  

 

 With an MACD chart, you will usually see three numbers that are used for its settings.

• The first is the number of periods that is used to calculate the faster moving average.
• The second is the number of periods that is used in the slower moving average.
• And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

For example, if you were to see "12, 26, 9" as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:

• The 12 represents the previous 12 bars of the faster moving average.
• The 26 represents the previous 26 bars of the slower moving average.
• The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the green lines in the chart above).

There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average.

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.

This is called divergence because the faster moving average is "diverging" or moving away from the slower moving average.

As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is "converging" or getting closer to the slower moving average.

And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!

Ok, so now you know what MACD does. Now we'll show you what MACD can do for YOU.

MACD Moving Average Crossovers

 The primary method of interpreting the MACD is with moving average crossovers. When the shorter-term 12-period exponential moving average (EMA) crosses over the longer-term 26-period EMA a buy signal is generated; this is seen on the chart below with the two purple lines.

  

Remember that the MACD line (the blue line) is created from the 12-period and 26-period EMA. Consequently:

1. When the shorter-term 12-period EMA crosses above the longer-term 26-period EMA, the MACD line crosses above the Zero line.
2. When the 12-period EMA crosses below the 26-period EMA, the MACD line crosses below the Zero line.

Moving Average Crossover Buy Signal

A buy signal is generated when the MACD (blue line) crosses above the zero line.

Moving Average Crossover Sell Signal

When the MACD crosses below the zero line, then a sell signal is generated.
The prior buy and sell signals get a person into a trade later in the move of a stock or future. A more common buy and sell signal is shown in the graph below

Most Common MACD Buy and Sell Signals

MACD Buy Signal

A buy signal is generated when the MACD (blue line) crosses above the MACD Signal Line (red line).

MACD Sell Signal

Similarly, when the MACD crosses below the MACD Signal Line a sell signal is generated.

The MACD moving average crossover is one of many ways to interpret the MACD technical indicator. Using the MACD histogram and MACD divergence warnings are two other important methods of using the MACD.

MACD Histogram

The MACD Histogram is simply the difference between the MACD line (blue line) and the MACD signal line (red line). The MACD histogram is illustrated in the chart below

Two important terms are derived from the MACD histogram and are illustrated above in the chart

• Convergence: The MACD histogram is shrinking in height. This occurs because there is a change in direction or a slowdown in the stock, future, bond, or currency trend. When that occurs, the MACD line is getting closer to the MACD signal line.
• Divergence: The MACD histogram is increasing in height (either in the positive or negative direction). This occurs because the MACD is accelerating faster in the direction of the prevailing market trend.

When a stock, future, or currency pair is moving strongly in a direction, the MACD histogram will increase in height. When the MACD histogram does not increase in height or begins to shrink, the market is slowing down and is a warning of a possible reversal. The graph below

The letter "T" represents when the top or peak of the MACD histogram occurs. In contrast, the letter "B" shows when the bottom of the MACD histogram occurs. Notice how closely the tops and bottoms of the MACD histogram are to the tops of the Nasdaq 100 e-mini future.

MACD Histogram Buy Signal

When the MACD histogram is below the zero line and begins to converge towards the zero line.

MACD Histogram Sell Signal

When the MACD histogram is above the zero line and begins to converge towards the zero line.

Note: In the example above, three consecutive days of shrinking MACD histogram from top or bottom served as the buy or sell signals shown with arrows. This is an agressive example. One could wait until the MACD histogram went to zero, but that would be the same signal as the MACD moving average crossover.

The MACD is not only good for buy and sell signals, the MACD can be used for warnings of potential change in the direction of stocks, futures, and currency pairs.

MACD Divergences

Bearish divergence occurs when a technical analysis indicator is suggesting that a price should be going down but the price of the stock, future, or currency pair is continuing to maintain its current uptrend.

Bullish divergence occurs when the indicator is indicating that price should be bottoming and heading higher, yet the actual price action is continuing downward.

These valuable divergences can signal to get out of a long or short position before profits erode. The following chart shows some of these divergences:

High #1 to High #2

Looking at the E-mini S&P 500 future, from High #1 to High #2, the futures contract made higher highs, which is usually viewed as bullish. However, the MACD moving average failed to make a new high. This bearish divergence was an early warning sign of things to come with the contract.

Low #1 to Low#2

In yet another bearish sign for the E-mini S&P 500 futures contract, the future made higher lows from Low #1 to Low #2, which again is usually considered positive. Nevertheless, the MACD technical indicator made a clear lower low from Low #1 to Low #2. This bearish divergence warned of the impending downturn of the contract  and the market as a whole.

Low #2 to Low #3

In addition to bearish and bullish divergences, the MACD can confirm price movement as well. The E-mini S&P 500 futures contract made a substantial lower low which was confirmed by the MACD when it made a lower low as well.

As seen throughout the MACD sections, the MACD is a versatile tool giving clear buy and sell signals and giving warnings of impending price changes.