MACD - Moving Average Convergence Divergence
Introduction:
The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security's price. The MACD is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA. The result of this subtraction is the MACD line. A nine-day EMA of the MACD called the 'signal line,' is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals.
Formula for MACD:
MACD = 12-Period EMA - 26-Period EMA
Signal Line = 9-Period EMA of MACD Line
Where:
- The 12-Period EMA is the Exponential Moving Average over the past 12 periods.
- The 26-Period EMA is the Exponential Moving Average over the past 26 periods.
- The Signal Line is the Exponential Moving Average over the past 9 periods of the MACD Line.
Interpretation of MACD:
- 1. Crossovers: When the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell. Conversely, when the MACD rises above the signal line, the indicator is bullish and suggests that it might be time to buy.
- 2. Divergence: When the security's price diverges from the MACD, it signals the end of the current trend. For example, a bullish divergence occurs when the MACD forms two rising lows that correspond with two falling lows on the price. This is a signal that the bullish trend is about to resume.
- 3. Overbought/Oversold Conditions: The MACD is also useful in identifying potential overbought or oversold conditions in a security's price movement. Although the MACD does not have bounds, overbought and oversold conditions are identified through the divergence and crossover principles.
Practical Applications:
- 1. Trade Signal Generation: Traders can use the MACD crossovers and divergence as signals to buy or sell a security. The crossover of the MACD line above the signal line is used as a buy signal, while a crossover below is used as a sell signal.
- 2. Trend Confirmation: The MACD can also be used to confirm the direction of a trend. If the MACD is moving in the same direction as the trend, it can be considered as confirmation that the trend is likely to continue.
- 3. Momentum Measurement: Since the MACD is a momentum indicator, it can provide insight into the strength of a price move. The distance of the MACD line from the signal line can indicate the momentum's strength.
