How Does Moving Average Convergence Divergence (MACD) works?

Studying Market Trends Using MACD Oscillator

Trend trading is a common use of the MACD. But unlike other oscillators MACD can't be used to detect overbought and oversold conditions. MACD instead measures momentum and trend strength, and is compared to the signal line in order to trigger trading signals.

Trading signals are provided by the line oscillator, which is similar to the two-line moving mean system. It displays the relationship between two moving averages for a security price that have been calculated over different periods. MACD refers to the calculation of the difference between the fast-moving 12-period-moving mean and the 26-period-moving mean .. The MACD line is the result. To indicate trading signals, a nine-day EMA (exponential Moving Average) is plotted against the MACD line. Gerald Appeal created the MACD concept in the late seventies.

How does the Indicator work?

MACD transforms two-moving lines into an oscillator. It combines momentum and trend following. It's a simple tool that compares data points and is calculated using a series of mathematical means. Trading on technical charts is not easy. It is important to identify the trend as it is where you can make the most money.

MACD oscillates between the 'zero line' and crosses over or below that line to reflect moving average convergence, divergence and crossover. MACD is not bound, so it can't be used to identify overbought or oversold levels. The chart is used to identify signal line crossovers and centreline crossovers for trading signals.

MACD is calculated by measuring the closing price of stock over the time period. For greater oscillation, the fast-moving average line (12-days MA) is used. The longer moving average reacts less to price changes in the underlying security. When the MAs are separated, divergence can occur.

If the MACD line crosses above the "zero" line, it is an indicator that there is upside movement. The upward thrust will gain momentum as the line moves away from its centreline. MACD crossing below the "zero" line indicates market decline.

The Formula

MACD is based on a simple formula. It is the difference in 12-days and 26 day exponential moving averages.

MACD= (12-days EMA – 26-days EMA).

Signal line = 9-day EMA for MACD

MACD Histogram= MACD Signal Line

For studying trend strength, the MACD line, signal and MACD histogram are combined. To identify turns, the 9-day signal line acts like a cursor. The histogram measures the difference between the MACD line and the signal line. If the histogram shows a positive value, then the MACD line is higher than the signal line. This indicates an uptrend. Negative values will indicate an uptrend.

Including MACD Oscillator in Trading Strategy

MACD oscillator provides visual indications of when the trend changes. MACD signal line crossing is the most commonly used indicator by traders to determine a bullish and bearish trend. It is easier to identify a turn when the signal line follows MACD. Bullish crossovers occur when MACD crosses below the signal line. Chartists also record a bearish crossover when the MACD line crosses below that signal line. A crossover can last from a few days to a few weeks when it occurs.

MACD trend identifying oscillator is an important tool in trading strategies. Here's why:

It's a simple indicator that provides trading signals.

MACD can sometimes offer trend reversal signals ahead

- The 9-day EMA smoothes out the noise

Additional signals regarding trend strength are provided by MACD

- It provides updated signals in comparison to the moving average

MACD can be used in trading strategies, but the caveats are the same for all charting tools.

MACD oscillator has too many crossovers. This adds to confusion. False positives are when the MACD line crosses the signal line. It also fails to forecast all reversals. MACD oscillator, to put it another way, indicates too many reversals which don't happen and not enough reversals which do.

Even if there is only a slight upward trend in stock prices, the crossover can still occur. The MACD chart will not show a false positive. The crossover should be viewed by traders as a change in trend. False reversals will see the MACD line fall back to zero.

To confirm a reversal, traders should study MACD oscillator and other charting tools. Signal line crossovers at negative or positive extremes is another problem. To push momentum to the extreme, it takes substantial movement in underlying stock volumes. Chartists confirm such extremes using historical data.

Conclusion

MACD is an innovative tool. It is unique because it can serve as both an oscillator AND a crossover indicator, unlike other oscillators. It combines momentum and trend. This can be applied to daily, weekly or monthly charts. MACD has its limitations. MACD can often signal too many reversals that don't actually occur. Chartists often use MACD histograms to verify trend reversal to avoid this problem. When using the oscillator in trading strategies, be aware of its strengths and weaknesses.