Moving average convergence divergence macd: Meaning, Criticisms & Real-World Uses

What Is Moving Average Convergence Divergence (MACD)?

Moving Average Convergence Divergence (MACD) is a momentum indicator used in technical analysis that reveals changes in the strength, direction, momentum, and duration of a trend in a security's price. As a key tool within the broader category of technical analysis, the MACD takes two exponential moving averages (EMAs) of a security's price and subtracts the longer-period EMA from the shorter-period EMA to create the MACD line. A second line, known as the signal line, is then generated by taking an EMA of the MACD line itself. The relationship between these two lines, along with a histogram, provides trading signals for market participants.

History and Origin

The Moving Average Convergence Divergence (MACD) indicator was developed by Gerald Appel in the late 1970s.¹⁰ Appel, a professional money manager and prolific inventor of technical analysis tools, sought to create a visually intuitive and easily interpretable indicator that could identify underlying trends without generating excessive "whipsaws" or false signals from market noise.⁸, ⁹ His original concept focused on the convergence and divergence of two moving averages.⁷

In 1986, Thomas Aspray further enhanced the MACD by adding a histogram feature.⁵, ⁶ This histogram, which plots the difference between the MACD line and the signal line, was introduced to help anticipate crossovers between the MACD line and the signal line, providing an earlier indication of potential shifts in momentum.⁴ The combination of these elements made the MACD one of the most widely used oscillators in financial markets.

Key Takeaways

The Moving Average Convergence Divergence (MACD) is a momentum-based technical analysis indicator.
It consists of an MACD line, a signal line, and a histogram, all derived from exponential moving averages of a security's price.
Traders use the MACD to identify trend direction, momentum, and potential buy or sell trading signals through crossovers and divergences.
The MACD is considered a lagging indicator because it is based on historical price data.
Common interpretations involve analyzing crossovers of the MACD and signal lines, as well as divergences between the MACD and price action.

Formula and Calculation

The Moving Average Convergence Divergence (MACD) is calculated using three exponential moving averages (EMAs) with specific periods, typically 12, 26, and 9 days.

MACD Line: The MACD line is calculated by subtracting the 26-period EMA from the 12-period EMA of a security's closing price.
$\text{MACD Line} = \text{12-Period EMA} - \text{26-Period EMA}$
The exponential moving average (EMA) gives more weight to recent prices, making it more responsive than a simple moving average.
Signal Line: The signal line is a 9-period EMA of the MACD line itself.
$\text{Signal Line} = \text{9-Period EMA of MACD Line}$
MACD Histogram: The histogram represents the difference between the MACD line and the signal line.
$\text{MACD Histogram} = \text{MACD Line} - \text{Signal Line}$

The choice of 12, 26, and 9 periods for daily charts is traditional, representing approximately two weeks, one month, and one and a half weeks of trading, respectively. However, these parameters can be adjusted by analysts based on their trading strategy and the specific timeframes they are analyzing.

Interpreting the MACD

Interpreting the Moving Average Convergence Divergence (MACD) involves observing the relationship between its components: the MACD line, the signal line, and the histogram.

Crossovers: A common interpretation involves crossovers between the MACD line and the signal line. When the MACD line crosses above the signal line, it is often seen as a bullish signal, suggesting upward momentum. Conversely, when the MACD line crosses below the signal line, it can indicate a bearish signal, suggesting downward momentum. These crossovers are key for identifying potential entry or exit points.
Centerline Crossovers: The MACD line oscillates above and below a zero line. When the MACD line crosses above the zero line, it indicates that the 12-period EMA has crossed above the 26-period EMA, suggesting a shift from negative to positive momentum. A cross below the zero line indicates the opposite. These centerline crossovers can signify major trend shifts.
Divergence: Divergence occurs when the price of an asset moves in one direction while the MACD moves in the opposite direction. For instance, if a security's price makes new highs but the MACD fails to make new highs, it could signal a bearish divergence, indicating weakening upward momentum and a potential trend reversal. Conversely, a bullish divergence might occur if the price makes new lows but the MACD makes higher lows, suggesting weakening downward momentum. Identifying chart patterns in conjunction with MACD divergences can provide stronger confirmation.

These interpretations are used by trend following traders to gauge the strength and direction of price movements and potential reversals.

Hypothetical Example

Consider a hypothetical stock, XYZ Corp., that has been trending upwards. An analyst using the Moving Average Convergence Divergence (MACD) observes the following:

Day 1: XYZ Corp.'s price is rising. The 12-day EMA is 52.00 and the 26-day EMA is 50.00.
- MACD Line = 52.00 - 50.00 = +2.00
- Assume previous MACD readings result in a 9-day Signal Line of +1.80.
- MACD Histogram = +2.00 - +1.80 = +0.20 (positive, suggesting upward momentum)
Day 5: XYZ Corp.'s price continues to rise, but at a slightly slower pace. The 12-day EMA is now 53.50, and the 26-day EMA is 52.00.
- MACD Line = 53.50 - 52.00 = +1.50
- The 9-day Signal Line, based on the recent MACD values, has increased to +1.60.
- MACD Histogram = +1.50 - +1.60 = -0.10

In this scenario, while XYZ Corp.'s price is still rising, the MACD line has decreased from +2.00 to +1.50, and it has crossed below its signal line (from being above it to now slightly below). This MACD line crossover, reflected by the histogram turning negative, could be a preliminary indication of weakening upward momentum indicator and potential consolidation or reversal, even though the price is still higher than on Day 1. This would prompt the analyst to look for further confirmation from other indicators or price action.

Practical Applications

The Moving Average Convergence Divergence (MACD) is widely applied in analyzing various financial markets, including equities, foreign exchange, and commodities. Investors and traders utilize MACD primarily as a momentum indicator to:

Identify Trend Strength and Direction: The MACD line's position relative to the zero line and its general direction can indicate whether a market is in an uptrend or downtrend and the strength of that trend. A rising MACD above zero points to a strong uptrend, while a falling MACD below zero suggests a strong downtrend.
Generate Buy and Sell Signals: Crossovers between the MACD line and the signal line are frequently interpreted as trading signals. A bullish crossover (MACD above signal line) suggests a potential buying opportunity, while a bearish crossover (MACD below signal line) indicates a potential selling or shorting opportunity.
Spot Divergences: As noted in interpretation, divergences between the MACD and the security's price can forewarn of impending trend reversals. This is particularly useful for traders looking to anticipate shifts in market sentiment before they are fully reflected in price movements.
Complement Other Indicators: The MACD is often used in conjunction with other technical analysis tools, such as the Relative Strength Index (RSI) or support and resistance levels, to confirm signals and develop more robust trading strategy. Morningstar highlights that MACD helps traders confirm trends and reversals, but also emphasizes that it works best when combined with other indicators.

Limitations and Criticisms

Despite its popularity, the Moving Average Convergence Divergence (MACD) has several limitations that market participants should consider. A primary criticism is that the MACD is a lagging indicator.³ Because it is derived from historical price data, its signals are generated after price movements have already occurred, which can lead to delayed entry or exit points in fast-moving markets. This inherent lag means that by the time an MACD signal appears, a significant portion of the trend may have already transpired.²

Additionally, the MACD can generate false signals or "whipsaws," particularly in markets characterized by low market volatility or sideways trading ranges. In such conditions, the MACD and signal lines may cross frequently, producing numerous signals that do not lead to significant price movements, leading to potential misjudgment and impact on risk management.¹ While divergences can be powerful, they do not guarantee future price action and can sometimes fail to materialize into a trend reversal. Analysts must exercise careful judgment and use the MACD as part of a comprehensive trading strategy rather than relying solely on its signals.

Moving Average Convergence Divergence (MACD) vs. Relative Strength Index (RSI)

The Moving Average Convergence Divergence (MACD) and the Relative Strength Index (RSI) are both popular momentum indicators used in technical analysis, but they measure momentum in different ways and serve distinct purposes.

The MACD is a trend-following momentum indicator that shows the relationship between two exponential moving averages of a security's price. It helps identify the direction, strength, and duration of a trend, as well as potential reversals through its convergence and divergence with price. It is unbounded, meaning there are no upper or lower limits to its values.

In contrast, the RSI is a momentum oscillator that measures the speed and change of price movements. It oscillates between 0 and 100, with readings typically above 70 considered overbought and below 30 considered oversold. The RSI is primarily used to identify potential overbought or oversold conditions in an asset, which may precede a price reversal. While both indicators measure momentum, the MACD focuses more on trend direction and momentum shifts, whereas the RSI focuses on the magnitude of price changes to identify extreme conditions.

FAQs

What does it mean when the MACD crosses above the signal line?

When the MACD line crosses above the signal line, it is often interpreted as a bullish signal, suggesting that the short-term momentum of a security is increasing relative to its longer-term momentum. This can indicate a potential buying opportunity.

Is MACD a leading or lagging indicator?

The MACD is considered a lagging indicator because it is calculated using historical price data, specifically exponential moving averages. This means its signals are generated after a price movement has already begun.

Can MACD be used for all types of securities?

Yes, the Moving Average Convergence Divergence (MACD) can be applied to various types of financial markets and securities, including stocks, commodities, and currencies. However, its effectiveness may vary depending on the asset's market volatility and whether it is trending or ranging.

What are the standard settings for MACD?

The most commonly used settings for MACD are 12, 26, and 9. This means the MACD line is the difference between the 12-period and 26-period exponential moving averages, and the signal line is a 9-period EMA of the MACD line. These settings can be adjusted based on the analyst's preferences and the timeframe being studied.