Moving Average Convergence Divergence (MACD)

Trend followers follow daily or weekly momentum indicators. Short-term traders may still find the same indicators powerful, but they are two very different forms of trading and investing.

The Moving Average Convergence Divergence (MACD) is a versatile and widely used technical indicator that helps investors identify trends, momentum shifts, and potential entry or exit points in financial markets.

MACD consists of three primary components:

• MACD (Blue Line): This is the difference between the 12-period and 26-period Exponential Moving Averages (EMA). The MACD line moves faster in response to short-term price changes.
• Signal Line (Purple Line): Often a 9-period EMA of the MACD line, the signal line acts as a trigger for buy and sell signals. It smooths out the MACD line’s fluctuations, providing clearer entry and exit points.
• Histogram (in Yellow): Represented as bars on the MACD indicator, the histogram shows the difference between the MACD line and the signal line. It visually depicts the momentum of price movements.

Example Using Daily Chart

When the blue line crosses the purple line, the histogram value becomes positive and is read as a buy signal. Conversely, when the histogram display is negative, the purple line has crossed below the blue line turning momentum negative, constituting a sell signal.  

purple line has crossed below the blue line turning momentum negative, constituting a sell signal. 

Investors may view this as a signal to sell or take profits, especially if other indicators confirm a weakening trend.

Understanding the Zero Line

The Zero Line on the MACD indicator is crucial for interpreting trend strength.

When the MACD line is above the zero line, it indicates that the short-term EMA is above the long-term EMA, signaling bullish momentum.

Conversely, when the MACD line is below the zero line, the short-term EMA is below the long-term EMA, indicating bearish momentum.

Common Use with Other Indicators

MACD is often used in conjunction with other technical indicators to confirm signals and improve trading accuracy:

• Moving Averages: Combining MACD with simple or exponential moving averages helps investors confirm trend direction and filter out false signals.
• Relative Strength Index (RSI): RSI measures overbought or oversold conditions. When RSI confirms MACD signals, investors gain more confidence in their trades.
• Volume Analysis: High trading volumes alongside MACD crossovers can validate price movements, suggesting increased market participation.

Wait for MACD crossovers to be confirmed by other indicators or market conditions before making trading decisions. Another signal that traders look for is a divergence from price. The MACD line should move up and down with the trend of price and if it starts to diverge, that might indicate a change in the trend of price.

What’s Divergence?

Divergence occurs when the price of an asset moves in the opposite direction of a technical indicator, such as the MACD. It suggests a potential change in momentum and often precedes a reversal or significant correction in price. Let’s delve into the concept of divergence with an example using the MACD indicator.

Divergence occurs in two primary forms:

Regular Bullish Divergence

Regular bullish divergence forms when the price of an asset forms a lower low, but the MACD indicator forms a higher low. This indicates that while the price is showing weakening downward momentum, the MACD is suggesting that bullish momentum might be building.

This discrepancy suggests that selling pressure is decreasing, and a potential reversal or upward movement could be imminent.

Regular Bearish Divergence

Regular bearish divergence forms when the price of an asset forms a higher high, but the MACD indicator forms a lower high. This indicates that while the price is reaching higher peaks, the momentum indicated by the MACD is weakening.

This divergence suggests that buying momentum may be waning, and a potential reversal or downward movement could follow.

Both divergences are most significant when they occur at relatively overbought/oversold levels.

Investors often use divergence alongside other technical indicators and fundamental analysis to confirm signals and strengthen their trading decisions. It can help traders anticipate trend reversals, avoid false signals, and better time entry and exit points in the market.

As with any technical analysis tool, it’s essential to combine divergence signals with other forms of analysis and risk management strategies to maximize its effectiveness in trading decisions.

MACD’s versatility make it a cornerstone of technical analysis, offering investors a powerful tool for navigating the complexities of financial markets.