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MACD (Moving Average Convergence-Divergence)
Developed by Gerald Appel in the late seventies, Moving Average Convergence-Divergence
(MACD) is one of the simplest and most effective momentum indicators available.
MACD turns two trend-following indicators, moving averages, into a momentum
oscillator by subtracting the longer moving average from the shorter moving
average. As a result, MACD offers the best of both worlds: trend following and
momentum. 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 MACD is unbounded, it
is not particularly useful for identifying overbought and oversold levels.
MACD is computed as a combination of two Exponential Moving Averages (EMA),
one with a longer step period than the other. The longer EMA is referred to
as "long step" and the shorter EMA as "short step." The
result of this computation is [what is called] the MACD line. A second line
is generated (called the Signal line) which is an Exponential Moving Average
of the MACD line. The step value of this EMA is called the "signal step."
Hence, MACD has three variables: Long step, short step, and signal step.
MACD is
a combination of 3 EMA's, the MACD line (red) is a combination of two EMA's,
while the signal line (green) is an EMA of the MACD (red) line. MACD is useful
for predicting direction.
Interpretation
As its name implies, MACD is all about the convergence and divergence of
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 is faster and responsible for most MACD movement.
The longer moving average (long step) is slower and less reactive to price changes
in the underlying security.
MACD oscillates above and below the zero line, which is also known as the
centerline. These crossovers signal that the shorter EMA has crossed the longer
EMA. The direction, of course, depends on direction of the moving average cross.
Positive MACD indicates that the shorter EMA is above the longer EMA. Positive
values increase as the shorter EMA diverges further from the longer EMA. This
means upside momentum is increasing. Negative MACD indicates that the shorter
EMA is below the longer EMA. Negative values increase as the shorter EMA diverges
further below the longer EMA. This means downside momentum is increasing.
Signal Line Crossovers
Signal line crossovers are the most common MACD signals. The signal line
is a 9-day EMA of MACD. As a moving average of the indicator, it trails MACD
and makes it easier to spot turns in MACD. A bullish crossover occurs when MACD
turns up and crosses above the signal line. A bearish crossover occurs when
MACD turns down and crosses below the signal line. Crossovers can last a few
days or a few weeks, it all depends on the strength of the move.
Signal crossovers are quite common. As such, due diligence is required before
relying on these signals. Signal line crossovers at positive or negative extremes
should be viewed with caution. Even though MACD does not have upper and lower
limits, chartists can estimate historical extremes with a simple visual assessment.
It takes a strong move in the underlying security to push momentum to an extreme.
Even though the move may continue, momentum is likely to slow and this will
usually produce a signal line crossover at the extremities. Volatility in the
underlying security can also increase the number of crossovers.
Centerline Crossovers
Centerline crossovers are the next most common MACD signals. A bullish centerline
crossover occurs when MACD moves above the zero line to turn positive. This
happens when the 12-day EMA of the underlying security moves above the 26-day
EMA. A bearish centerline crossover occurs when MACD moves below the zero line
to turn negative. This happens when the 12-day EMA moves below the 26-day EMA.
Centerline crossovers can last a few days or a few months. It all depends
on the strength of the trend. MACD will remain positive as long as there is
a sustained uptrend. MACD will remain negative when there is a sustained downtrend.
MACD is special because it brings together momentum and trend in one indicator.
This means MACD will never be far removed from the actual price movements of
the underlying security. This unique blend of trend and momentum can be applied
to daily, weekly or monthly charts.
MACD is not particularly good for identifying overbought and oversold levels.
Even though it is possible to identify levels that are historically overbought
or oversold, MACD does not have any upper or lower limits to bind its movement.
MACD can continue to overextend beyond historical extremes during sharp moves.
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