How to trade using Moving Average Convergence -Divergence (MACD)

How to trade using Moving Average Convergence-Divergence (MACD)

The Moving Average Convergence-Divergence or called MACD in short is an indicator that was developed by Gerald Appel in the seventies. The MACD indicator is a simple and very effective element in technical analysis. It is on e of thee widely used indicator. The MACD uses two different moving averages namely one long moving average and a short moving average. The short moving average is subtracted from the long moving average and the result is available for analysis. When the moving averages move towards each other or converge, it is called Convergence. When the moving averages move away from each other or diverge, it is known as Divergence. So we can say that the MACD tells us the trend and the momentum of the market. Traders look for crossover for entering trade, and divergence to continue in the long or short positions they already have entered.

How to interpret the MACD?

Let us take a widely used MACD setting and try to understand.  The closing prices are used for the calculation of Exponential Moving Averages. These Exponential Moving Averages can be varied according to the users own trading methodology. The shorter moving average (12-day) is fast and the longer moving average (26-day) is slow. It is this factor makes up the MACD signals.

The MACD line in our example is a 26 day Exponential Moving Average deducted from 12 day Exponential Moving Average. This forms the main MACD line in chart. The signal line is 9 day Exponential Moving Average. The Histogram will turn positive or negative depending on the signal. This is also important element in a chart.

 

Interpretation

When interpreting the MACD we have to look for the EMA lines that have been plotted in a chart. When the 12 day EMA moves away from the 26 day (or above the 26 day EMA), creating a divergence a positive value is plotted in the chart. This is an indication that the market trend is on the upper side.

When the two averages are moving towards each other convergence can occur. In this condition the 12 day EMA will be below the 26 day EMA. This indicates the momentum on the downside is on the increase. In other words the market is on the downtrend.

Signal Line Crossovers

An analyst has to look for crossover signals in a MACD chart. Based on the volatility of the underlying stock a bullish or bearish crossover signals are generated in a MACD chart. Whenever the MACD turns up and crosses above the signal line a bullish crossover is interpreted.  Whenever the MACD turns downwards and crosses the signal line a bearish crossover is seen. We can observe these crossovers to last for days or even weeks. This is one point to note because sometimes we notice despite the uptrend in the market the MACD can show bearish divergence. Similarly in a downtrend market the MACD may tend to give crossover signals.  Because of this nature the overbought and oversold levels cannot be assessed. The best way to approach this problem is to change the time frame to weekly mode and observe the chart. This way we can assess the quality of the signals.

Conclusions

The MACD indicator is particularly useful because it indicates both the momentum and the trend in a given market. It can be applied in daily, weekly or monthly charts. The standard setting for MACD can be customized depending on the user’s choice. Its sensitively can be fine tuned for less crossovers that can happen frequently to give meaningful trading signals.