What is the MACD Indicator?

The MACD – Moving Average Convergence/Divergence Index – is an indicator which, as its name suggests, uses moving averages at the basis of its calculation. But unlike basic moving averages which are overlaid on a chart, the MACD indicator is displayed underneath the chart itself, as can be seen below:

The MACD is used to help identify changes in the strength, direction, momentum and duration of a trend in a particular market. Trend identification is of great importance to most traders as getting on the right side of a trend can be the easiest way to be profitable in financial markets – as long as proper money and risk management is undertaken. The MACD is a collection of lines which are typically calculated from daily closing prices. First of all there is the horizontal “zero line”. Then we have the MACD line itself which is the difference between a short and longer exponential moving average (EMA). This is the blue line in these examples. The default setting is generally 12 and 26 periods (usually days), although traders can easily customise these if they have a preferred setting. The next default setting is a nine-period EMA of the MACD line, called the Signal line, which is shown in red. This MACD format is known as 26,12,9. The difference (or divergence) between the MACD and Signal lines is shown in the “histogram”. The histogram appears as the black vertical lines in these examples.

There are a number of different ways that traders can use and interpret this indicator. They can look for the MACD (blue line) to cross above or below the Signal (red line) to give buy and sell signals respectively. They can also look at both lines to see when they cross above or below the zero line. In the illustration below, a number of “buy” signals have been circled when both lines are below the zero line and when the MACD has crossed above the signal line. A couple of “Sell” signals have been circled when both lines are above the zero line and the MACD has crossed below the signal line. As can be seen with the final “sell” signal on the far right, a “buy” indication turns up quite promptly when the MACD crosses back above the signal line. However, in this instance neither the MACD nor Signal lines had broken below the zero line. For some traders this is not an issue, as it is the “negative” crossover on its own (the MACD breaks below the Signal line) that gives them the sell signal.

Many traders also look for divergences between the price of the financial instrument, the MACD and signal lines and the histogram. This divergence shows when the MACD and actual price are not in agreement. For example, Bullish Divergence occurs when prices record lower lows, but the MACD records a higher low. The movement of price provides evidence of the current trend, but the MACD is flagging up changes in momentum which can sometimes precede a significant price reversal. Bearish Divergence is the opposite whereby the price records a higher high while the MACD records a lower high. An example of a Bearish Divergence can be seen below. This is a chart of the S&P500 capturing most of this year’s trade. From the middle of July to the end of August the S&P was creeping higher while the MACD was sloping down and showing negative divergence. Then this tension was resolved when the S&P sold off sharply.

Technical indicators can be extremely helpful in analysing financial markets. However, it is important to note that technical analysis is fallible. Don’t rely on one indicator alone. The MACD is often paired up with Bollinger Bands to help eliminated misleading signals. Also, be aware that many signals thrown out by the indicators can be interpreted in different (and often contradictory) ways.

by David Morrison of Spread Co

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.