The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of price. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the “signal line”, is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.
First Some History
Developed by Gerald Appel, Moving Average Convergence/Divergence (MACD) is one of the simplest and most reliable indicators available. MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics. These lagging indicators are turned into a momentum oscillator by subtracting the longer moving average from the shorter moving average. The resulting plot forms a line that oscillates above and below zero, without any upper or lower limits.
Benefits of the MACD
One of the primary benefits of MACD is that it incorporates aspects of both momentum and trend in one indicator. As a trend-following indicator, it will not be wrong for very long.
The use of moving averages ensures that the indicator will eventually follow the movements of the underlying security. By using exponential moving averages, as opposed to simple moving averages, some of the lag has been taken out.
The default settings for the MACD which we will use are:
Slow moving average – 26 days
Fast moving average – 12 days
Signal line – 9 day moving average of the difference between fast and slow.
All moving averages are exponential.
Although there are three moving averages mentioned you will only see two lines. The simplest method of use is when the two lines cross. If the faster signal line crosses above the MACD line (The MACD line is calculated by the difference between the 26-day exponential moving average and the 12-day exponential moving average) then a buy signal is generated and vice versa.
It is also used as an overbought and oversold indicator. The higher above the zero both lines are the more overbought it becomes and the lower below the zero line both lines are the more oversold it becomes.
It may also lead to a stronger signal if the signal line crosses down when it is overbought and crosses up when it is oversold. The last common use of MACD is that of divergence.
If the MACD is making new lows and the price of the security is not making new lows that is one form of divergence (bullish divergence). Also, if the MACD has made a high and starts to head down but price continues up that is another type of divergence (bearish divergence) and may lead to an indication of a change in direction.
There are many ways to trade the MACD but one of our favourites are too use two different time frames. All you do is establish a trend in a higher time period than the one you intend to trade. For our higher time frame we like to use the 30 min chart and then drop down to the 5 min chart when conditions have been met on the 30 min chart..
As you can see from the 30 min chart example of the BSE Sensex below there was a buy signal on 12th December 06. The chart below (red arrow) shows the fast 9-day signal EMA (thin red line) crossing over the MACD line EMA (thin blue line).
The histogram represents the difference between MACD and its 9-day EMA. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.
After confirming the signal on the 30 min chart we then dropped to the lower time frame 5 min chart of the BSE Sensex and bought the rallies where the red arrows show, confident to stay long (to buy) as long as our higher time period MACD trend in the 30 min stayed intact. If the 30 min MACD signal line were to cross down we would have closed all long positions.
Also the MACD calculates the absolute difference between two moving averages and not the percentage difference. The MACD is calculated by subtracting one moving average from the other. As a security increases in price, the difference (both positive and negative) between the two moving averages is destined to grow. This makes its difficult to compare MACD levels over a long period of time, especially for stocks that have grown exponentially.
Having said that the MACD still is and will always be one of the few indicators that all traderslove and use daily and in many ways it is like seeing an old familiar friend you know you can rely on.