Gerald Appel developed the Moving Average Convergence/Divergence oscillator (MACD) in the late seventies. Traders have been using it ever since, making it one of the most popular tools for technical analysis on the market.
The beauty of MACD combination is its simplicity- it uses two trend-following indicators (moving averages) into an oscillator by subtracting the longer moving average from the shorter one. Because of this, you can follow trends and spot momentum reversals.
Signal line crossovers, centerline crossovers, and divergences are the three most important signals to look for when using the MACD. However, as this article will show, there are a few limitations of the MACD, such as false positives of trend reversals when using divergence signals.
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What Is Moving Average Convergence and Divergence (MACD)?
MACD represents the relationship between moving averages of a security price. Traders can calculate the MACD by subtracting the 26-period exponential average from the 12-period EMA. The difference creates the MACD line.
After obtaining the difference, add a nine-day EMA of the MACD called a “signal line” on top of the MACD line. This signal line represents critical buy and sell signals for traders and they can choose to buy securities when the MACD crosses above the signal line or sell when it crosses below. Crossovers, divergences, and rapid rises or falls.
The MACD formula is as follows: MACD- 12-period EMA – 26-period EMA
Subtracting the long-term EMA from the short-term EMA gives you the MACD. The exponential moving average (EMA) is a moving average that places more significance on recent data points. You can also refer to the EMA as the exponentially weighted moving average. The exponentially weighted moving average has more drastic shifts following price changes than simple moving averages (SMA).
Elements of the MACD
There are a few standard MACD signals. The two most common are the signal line crossover and the centerline crossover.
Signal Line Crossovers
The signal line crossover is the most common MACD indicator. As previously discussed, it represents the nine-day EMA of the MACD line. As a moving average, the signal line trails the MACD and identifies critical MACD turning points. A bullish crossover occurs when the MACD crosses above the signal line.
Bearish crossover signals occur when it drops below the signal line. These occurrences typically last a few days and traders should exercise caution when interpreting positive or negative extreme crossovers.
Centerline crossovers are also standard MACD signals. Bullish centerlines happen when the MACD line moves into positive above the zero line. These crossover signals occur when the 12-day EMA moves above the 26-day EMA and they can last anywhere from a few days to a few months. Their duration depends on the trend’s strength.
As long as there is an extended uptrend, the MACD will remain positive.However, the opposite is true during a sustained downtrend.
Divergences occur when the MACD shifts away from the underlying security’s price action. When securities record lower lows and the MACD forms a higher low, bullish divergences happen. The lower the lows in securities, the more confirmation of the downtrend. Higher lows signify more unpredictability in the downside momentum.
WIth divergences, slowing downside momentum can be the sign of a trend reversal or rally, a key indicator for trading entry strategies. When bullish divergences occur, they can underpin signal crossovers and cause breakouts.
What Is the Difference Between MACD Convergence and Divergence?
Traders can use the MACD to analyze the convergence and divergence of moving averages. The MACD indicator MACD convergence occurs when moving averages move toward each other. Divergence occurs when the moving averages move away from each other.
Shorter moving averages are faster and responsible for most MACD movements. Conversely, longer moving averages are slower and less volatile.
Learning from the MACD
The MACD has positive values whenever the 12-period EMA is above the 26-period EMS. When the 12-period EMA is below the 26-period EMA, they have negative values. The more distant the MACD is above or below its baseline, the more divergent its EMAs become.
MACDs typically use histograms to represent their data. The histogram plots the distances between the MACD and signal lines. If the MACD remains above the signal line, the histogram plots will be above the MACD baseline. If it is below the signal line, the histogram plots will be below the baselinThus, traders can use the MACD’s histogram to identify the bullish or bearish indicators previously discussed in this article.
Limitations of MACD
One of the limitations of the MACD is that it can portend a trend reversal, and then no trend reversal occurs. Divergence also doesn’t predict every reversal. Thus, there is a significant margin for error when using the MACD, so traders should understand these risks before relying too heavily on the MACD.
False-positive divergence happens when asset prices move sideways in range or triangle patterns after a trend. The slowing price momentum causes the MACD to change course from its previous extremes and it moves closer to the zero lines when actual reversals don’t occur.
MACD with the RSI and SMA
Traders can also use the MACD in conjunction with the relative strength indicator (RSI) and the simple moving average (SMA). Traders sometimes call this the MACD and RSI strategy. To understand these strategies, you first need a general understanding of both the RSI and the SMA.
Traders use the RSI indicator to analyze trend strength and reveal possible reversal points. It uses oversold and overbought levels with a 14-period baseline and traders can set the oversold and overbought levels to 20 and 80 or 30 and 70. Setting the indicator at 20 and 80 can eliminate some risk and it is less sensitive to price fluctuations.
An SMA is a technical indicator used to predict price trend continuation or reversal. Setting an SMA indicator calculates a specific price range’s average. Traders usually set the indicator between closing prices, and the number of price periods within that range determines the SMA.
MACD + RSI + SMA
Combining the MACD with the RSI and the SMA uses one leading RSI and two lagging MACD SMA indicators. The RSI predicts future price changes while the SMA trails and establishes potential trends. Taking this into account, you can use the RSI to predict reversal points while the SMA confirms the signals. As these two tools work together, the MACD can reveal trend strength and direction and solidify the RSI and SMA signals.
Conclusion- What You Can and Can’t Learn from the MACD Indicator
The MACD is one of the most widely used indicators in technical analysis and its simplicity shows us why. However, there are a few limitations to the MACD, such as its false positives when analyzing divergence, revealing the need for traders to exercise caution when using it.
Despite its drawbacks, the MACD is a powerful tool that traders can incorporate in their price action strategy. It is an insightful tool to spot short-term momentum shifts and reversal points. The MACD reveals signal line crossovers, centerline crossovers, and divergence signals, which are excellent ways to formulate buy and sell strategies. The MACD is also especially useful for intraday traders trying to spot short-term trend directions.
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