Moving Average Convergence/Divergence oscillator (MACD)
Developed by Gerald Appel in the late seventies, the Moving Average Convergence/Divergence oscillator (MACD) is one of the simplest and most effective momentum indicators available. The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter one. As a result, the MACD offers the best of both, trend following and momentum. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals. Because the MACD is unbounded, it is not particularly useful for identifying overbought and oversold levels.
Calculation
MACD Line: (12-day EMA - 26-day EMA)
Signal Line: 9-day EMA of MACD Line
MACD Histogram: MACD Line - Signal Line
The MACD line is the 12-Period Exponential Moving Average (EMA) less the 26-Period EMA. Closing prices are used for these moving averages. A 9-Period EMA of the MACD line is plotted with the indicator to act as a signal line and identify turns. The MACD Histogram represents the difference between MACD and its 9-Period EMA, the signal line. The histogram is positive when the MACD line is above its signal line and negative when the MACD line is below its signal line.
The values of 12, 26 and 9 are the typical settings used with the MACD, though other values can be substituted depending on your trading style and goals.
As its name implies, the MACD is all about the convergence and divergence of the two moving averages. Convergence occurs when the moving averages move towards each other. Divergence occurs when the moving averages move away from each other. The shorter moving average (12-Period) is faster and responsible for most MACD movements. The longer moving average (26-Period ) is slower and less reactive to price changes in the underlying security.
The MACD line oscillates above and below the zero line, which is also known as the centerline. These crossovers signal that the 12 EMA has crossed the 26 EMA. The direction, of course, depends on the direction of the moving average cross. Positive MACD indicates that the 12 EMA is above the 26 EMA. Positive values increase as the shorter EMA diverges further from the longer EMA. This means upside momentum is increasing. Negative MACD values indicate that the 12 EMA is below the 26 EMA. Negative values increase as the shorter EMA diverges further below the longer EMA. This means downside momentum is increasing.
Signal line crossovers are the most common MACD signals. The signal line is a 9 EMA of the MACD line. As a moving average of the indicator, it trails the MACD and makes it easier to spot MACD turns. A bullish crossover occurs when the MACD turns up and crosses above the signal line. A bearish crossover occurs when the MACD turns down and crosses below the signal line. Crossovers can last a few days or a few weeks, depending on the strength of the move.
Divergences form when the MACD diverges from the price action of the underlying security. A bullish divergence forms when a security records a lower low and the MACD forms a higher low. The lower low in the security affirms the current downtrend, but the higher low in the MACD shows less downside momentum. Despite decreasing, downside momentum is still outpacing upside momentum as long as the MACD remains in negative territory. Slowing downside momentum can sometimes foreshadow a trend reversal or a sizable rally.
A bearish divergence forms when a security records a higher high and the MACD line forms a lower high. The higher high in the security is normal for an uptrend, but the lower high in the MACD shows less upside momentum. Even though upside momentum may be less, upside momentum is still outpacing downside momentum as long as the MACD is positive. Waning upward momentum can sometimes foreshadow a trend reversal or sizable decline.
Divergences should be taken with caution. Bearish divergences are commonplace in a strong uptrend, while bullish divergences occur often in a strong downtrend. Yes, you read that right. Uptrends often start with a strong advance that produces a surge in upside momentum (MACD). Even though the uptrend continues, it continues at a slower pace that causes the MACD to decline from its highs. Upside momentum may not be as strong, but it will continue to outpace downside momentum as long as the MACD line is above zero. The opposite occurs at the beginning of a strong downtrend.