MACD: Moving Average Convergence Divergence

MACD is one of the most popular indicators among investors and traders, which is used with different time frames and expresses the rules of entry and exit, as well as the expiration of the signal. The strength of this strategy is that it follows the trend.

What is MACD Indicator?

The MACD stands for Moving Average Convergence Divergence. This indicator is the invention of Mr. Gerald Apple. This indicator is used in technical analysis to obtain power, direction, and acceleration in a trend. This indicator is often calculated using the final price. Unlike other indicators, the MACD indicator does not have a difficult formula to calculate.

MACD elements

Moving Average Convergence Divercange indicator includes three main elements listed below with a full description.

MACD Line: helps determine upward or downward in market trend. It is a combination of two moving averages, in other words, it is the result of subtracting two exponential moving averages of 26 and 12 days from the final price. It is worth noting that 26 and 12 are the default numbers of this indicator, you can change the numbers according to your needs.

 Signal Line: This line is obtained from a 9-day exponential moving average and is used to indicate buying or selling opportunities. A combination of the signal line with the MACD line is used for spotting potential reversals or entry and exit points.

Histogram: The difference between the MACD line and the signal line over time. By the mean, it is the graphical representation of the divergence and convergence of the MACD line and the signal line.

When the 12-day moving average is higher than the 26-day moving average, the MACD value is positive, and when the 12-day moving average is lower than the 26-day moving average, the MACD value is negative. The higher or lower the distance of the MACD from its Baseline is, the greater the distance between the two moving averages would be.

MACD elements

Although default settings for MACD are 12, 26, and 9-period exponential moving average but some technical analysts and traders change the periods in order to use more sensitive indicators. MACD (5, 35, 5) is a common choice in financial markets with longer timeframes, and weekly or monthly charts. 

How to use MACD?

Here is how to use the MACD indicator and its relative trading signals to make decisions for entry and exit points when trading in different financial markets.

Crossovers

As mentioned earlier in using MACD we are dealing with two moving averages at different speeds. The faster-moving average would definitely react to market price movements faster than the slower one. As soon as any new trend occurs in the market you can expect that the fast line reacts and cross the slower moving average. This is called “MACD crossover”. After that and the fast line starts to “diverge” or move away from the slower line. Traders interpret this occurrence as forming a new trend. It worth noting that at the time two moving averages cross histogram would temporarily disappear since the difference between the lines at the time of the cross is 0.

 As the fast line diverges away from the slow line in the way explained earlier we are expecting, the histogram gets bigger. This is a good indication of a strong trend.

Traders can understand it would be the time to buy when the MACD crosses above the signal line and it would be the time to sell when MACD crosses below the signal line. This is along with the speed of crossovers that can be taken as a signal of the market being overbought or oversold.

Buy signal with MACD indicator: As you can see in the picture below, where it is marked with a black rectangle, the blue line intersects the red line upwards and the histogram bars enter the positive phase from the negative phase. This is a buy signal for traders.

Sell signal with MACD indicator: In the next rectangle marked in red, the blue line intersects the red line at downward and the histogram bars enter the negative phase, indicating a sell signal.

MACD buy sell signal
indicating buy sell signals with MACD

Histogram in MACD indicator

Histograms are bar charts that are located at the top and bottom of the zero lines. As mentioned earlier the histograms are obtained from the difference between the MACD line and the signal line, so the greater the difference between the two lines, the longer the histograms and vice versa.

Positive histograms: The histograms above the zero line indicate that the MACD line is higher than the signal line.

The higher the histogram bars are, the higher the traders willing for the assets would be.

Negative histograms: The histograms at the bottom of the zero line, indicate that the MACD line is lower than the signal line.

The longer the histogram bars are in the negative phase, the more traders are willing to sell assets, and the smaller these bars are, the weaker the trader’s tend to sell is.

The change of phase and rotation of the histograms occurs earlier than the intersection of the two MACD oscillator lines, which is why it is important to give analysts early alertness.

In summery MACD helps investors and traders to understand whether the bullish or bearish movement in the price trend is strengthening or weakening. Like many technical analysis tools, this indicator cannot be used to make buy and sell decisions. It must be analyzed and further examined, taking into account other factors as well.

Divergences

One of the main uses of the MACD is to observe the divergences between the price and the MACD indicator. Divergences occur when the price trend is inconsistent with the oscillator trend and is divided into two categories: regular and hidden divergences, each of which is positive and negative.

divergence types

Regular Divergences

Regular divergences are a sign of a reversal of a trend. Negative divergence (RD-) occurs at the end of the uptrend and when there is a higher price ceiling, but the indicator fails to register a new price ceiling and considers it lower. This divergence suggests that buying pressure has been reduced, but the number and strength of buyers is still higher than sellers in the market. After observing this situation, risk management should be done because the possibility of changing the trend and the return of the declining market has increased.

Positive divergence (RD}) is formed at the end of the downtrend so that by lowering the price floor, the indicator fails and registers a higher floor. This divergence indicates a decrease in sales pressure, followed by a reversal of the downward trend.

Hidden Divergence

Hidden divergences can be used as a possible signal to indicate that the trend would keep going. By the mean they provide confirmation of the continuation of the price trend. Negative hidden divergence (HD-) is formed when the price reaches a lower ceiling than the previous ceiling, but the indicator registers the higher ceiling. This indicates the continuation of the downward trend.

positive hidden divergence (HD+) occurs when the floor price is higher than the previous floor, but the indicator creates a lower floor. This is a sign that the upward trend continues.

MACD in the cryptocurrency market

It is possible to use the MACD indicator for trading coins in the cryptocurrency market similar to stocks in finance markets. You just need to follow the formula above to plot out the signal line and study the result just the same way that is noted earlier.

Although it was mentioned earlier in the article that traders can change the default periods as a cryptocurrency trader keeps in mind that due to the high volatility of cryptocurrency markets, increasing the sensitivity of the MACD may be risky because it may result in more false signals and misleading information.

Limitations

One of the main problems with divergence is that it often signals a possible reversal incorrectly. Another problem is that divergence cannot predict the reversal of all trends. In other words, this indicator announces many signals that the trend is reversed, while it is not and in the meantime loses the prediction of some real reverse trends.

As you probably know moving averages by nature tends to lag behind price since they are just an average of prices over time. Considering the fact that MACD works based on moving averages so there may be a bit of lag. However, MACD is one of the most popular tools used by many traders in different markets.

Closing thoughts

The Average Convergence Divergence oscillator is one of the most useful and popular tools available in technical analysis. Since it is easy to use, and quite effective at identifying market trends. Similar to other indicators in technical analysis MACD does not always provide accurate results and may provide misleading signals especially in trading volatile assets. Consequently, it is important to use MACD with other indicators in order to reduce risks and confirm the result signals.

MACD highlights

Highlights

  • MACD line is the difference between 12-day and 26-day Exponential Moving Average.
  • The signal line is the 9-day exponential moving average
  • The histogram shows the difference (divergence) between the MACD line and the Signal line.
  • The normal settings of a MACD are 12, 26 and 9 and can be changed based on the trader’s decision
  • When the MACD line cuts the signal line in an uptrend it is a buy signal.
  • When the signal line cuts the MACD line in a downtrend it is a sell signal confirmation
  • MACD line diverges from the price line indicates the trend is ending.
 

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