MACD, Moving Average Convergence / Divergence
MACD, pronounced "Mac D" and which has nothing to do with fast food, stands for Moving Average Convergence/Divergence. The indicator was invented by Gerald Appel in the 1960's. It is one of the simplest indicators, as well as being considered quite reliable. The technique is to take the difference between two exponential moving averages (EMA's) with different periods. This produces what's generally referred to as an oscillator. An oscillator is so named because the resulting curve swings back and forth across a base line, in this case, zero.
MACD Technical Analysis
The popularity of the MACD is because of its ability to be used to quickly spot increasing short-term trends and changes. Because the MACD works on a differential of EMAs we need to completely understand the relationship between a short-term and long-term moving average.
As you can see from the chart below, many traders will watch for a short-term moving average (blue line) to cross over a longer-term moving average (red line) and use this to indicate upward or downward momentum. This crossover suggests that the price has recently been moving at a faster rate than it has in the past and is a common technical indicator to buy or sell, depending on direction.
Basically, a short-term MA crossing below a longer-term MA is used to indicate that the price of the security has been moving downward at a faster rate and that it may be a good time to go short. A short term MA crossing above a longer term MA is used to indicate that the price of the security has been moving upward at a faster rate and that it may be a good time to go long.
The MACD
If you follow the graph above, you will notice after the point of crossover, as the trend increases in strength (i.e. the price rises or falls faster and for a longer time), the two MA lines diverge away from each other. As the trend decreases in strength, the two MA lines converge toward each other. The diffence between the two EMAs is the convergence / divergence factor in a MACD indicator.
MACD = Short Term EMA - Long Term EMA
The MACD subtracts the long term EMA value from the short term EMA value and plots it onto an indicator chart. This results in either a positive value (if the trend is up) or a negative value (if the trend is down). The value that is plotted is an indication of how strong the trend is, meaning how large the divergence is. While the common default settings for the EMAs are 12 and 26 days, you can change those values to suit your trading method to find what works the best for you.
If the MACD is positive (i.e. the short term EMA is above the long term EMA), this indicates increasing upward momentum. Depending on your trading method, you may want to refrain from going short or if you were in a short position, this may be the indication to close out your position.
If the MACD is negative (i.e. the short term EMA is below the long term EMA), this indicates increasing downward momentum. Depending on your trading method, you may want to refrain from going long, or if you are in a long position, this may be the indication to close out your position.
MACD Technical Analysis
Many traders plot a separate moving average alongside the MACD, which is used to create an indication of when the momentum is shifting. A signal line, also known as the trigger line, is created by plotting a shorter period average (in this example we are using a nine-period average) of the MACD alongside the indicator on the chart. As you can see below, transaction signals are generated when the MACD line crosses through the signal line.
The basic long signal occurs when the MACD line crosses above the signal line, as shown in the circle on the left. The basic short signal is generated when the MACD crosses below the signal line, as shown in the circle on the right.
Care must be taken when the bullish signal occurs below the zero line. The MACD indicator when below the zero line is showing that the general trend is bearish, meaning overall the price is going down. While you may get a signal indicating to go long, it is possible it is just a point of resistance and the downtrend may yet continue soon, catching you in a losing position. The same thing goes with seeing a bearish signal when the MACD is above the zero line.
While the MACD is a popular and fairly accurate of market trends, you should always take care to interpret the indications as well as possible, and confirm the signals you see with other indications as well. The crossover could very well indicate a reversal, but it could also be indicating a short term sell-off before continuing on its current trend.
Another common signal that many traders watch for occurs when the indicator travels in the opposite direction of the security, known as divergence.
Advantages
The MACD indicator is a very useful tool that can help traders ensure that short-term direction is working in their favor. The signals and indications generated by the MACD indicator are easily interpreted and can be quickly incorporated into any short-term trading strategy. In general, the MACD is very accurate and reliable, as long as the signals are read properly and incorporated into a good trading method.
Disadvantages
The biggest disadvantage of using this indicator to generate action signals is that it becomes less reliable in choppy market trends. If the price of a security is volitile, you may get lulled into positions that may turn against you before seeing a consistant strong change in momentum. This means that you might be trading in and out of positions taking little profit, or even worse, losses that wind up causing more losses than gains over the long run. Of course, changing the parameters of the indicator calculations can help prevent that, by looking at shorter or longer relative timeframes. Again, you should experiment and find what works best with your trading method.
This choppy market can be severe because relatively small movements can cause the indicator to change directions quickly. The large number of false signals can result in a trader taking many losses. This strategy can become very expensive if you don't have a good trading method and pay attention to the market conditions.
Summary
The MACD indicator is the most popular tool in technical analysis because it gives traders the ability to quickly and easily identify the direction of short term trends and momentum. The clear action signals in strong markets help minimize the subjectivity involved in trading and the crosses over the signal line make it easy for traders to ensure that they are trading in the direction of the trend. Very few indicators in technical analysis have proved to be more reliable than the MACD, and this relatively simple indicator can quickly be incorporated into any short term trading strategy.
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