Moving Average Convergence Divergence (MACD) is the difference or distance between two moving averages. This trend-following momentum shows the relationship between two moving averages of an asset price when converging or diverging. It identifies moving averages that are showing new trends, which can be bullish or bearish.
The MACD formula
The MACD formula is a simple one. It is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period Exponential Moving Average. You will then plot a 9-day EMA of the MACD, called the signal line on top of the MACD line. The line can trigger a buy and sell signal.
How to trade using MACD
The Moving Average Convergence Divergence, as the name suggests, tracks the relationships between two moving averages, and the co-relationship between the two lines could be described as either convergent or divergent. It is convergent when the lines gravitate towards one another and divergent when they move apart. There are usually two moving averages of different speeds, which means that one will be faster than the other. So in a new trend, the fast one will cross over the slow line. After the moving average crossover has happened, the faster line would start to diverge, moving away from the slower line, which signals a new trend.
At the point of crossing, the histogram temporarily disappears, and this is because the difference between the lines at the point they were crossing is zero. When the trend is strong, the histogram gets bigger.
The MACD indicator has three components, and they are:
The MACD line
It is one of the essential components of this indicator; this is the fast-moving average. It shows the difference between two exponential moving averages. There are different moving averages, but the exponential moving average and the simple moving average are the most popular. The exponential moving average is preferred because it gives faster information about its current price than the simple moving average.
The signal line
It is the 9-period Exponential Moving Average of the MACD line. It is the slow line of the MACD indicator. The 9-period could be nine days if the daily chart is the 9 hours if it is on the 1-hour chart. The signal line trails the MACD line and makes it easier to spot MACD turns.
This is a graph that shows the distance between the MACD line. The oscillator revolves around the reading of zero. It measures the trajectory of the MACD, helping traders anticipate crossovers and showing the difference between the fast and the slow-moving averages by displaying bars. When price crosses, the MACD histogram disappears because it is the difference between the two lines. When they cross, the difference is zero. This phenomenon occurs when a price move is about to happen.
Below is a summary of what has been written above:
- MACD line: 12-period EMA – 26-period EMA
- Signal line: 9-period EMA of the MACD line
MACD Histogram: The more significant the gap between the 12-period EMA and 26-EMA, the bigger the histogram will be; the smaller the gap between 12-EMA and 26-EMA, the smaller the histogram will be.
How to use MACD indicator
Crossovers – When the MACD line crosses the signal line, the trend will change direction. When the MACD moves above the signal line, it is a bullish signal, and when it crosses below the signal line, it is a bearish signal.
No crossovers – This is when the MACD signal line touches the signal line without crossing it. It is to mean that the trend is going to continue. If this is combined with other indicators or strategies, it can confirm a price movement in a particular direction. For example, when there is a bullish trend, and the MACD line touches the signal line and bounces back, it confirms that the movement towards that direction continues.
Centerline crossover – This is when the MACD line crosses the centerline. When the line crosses from below to above the centreline, it is a bullish signal. Still, it is a bearish signal if it crosses from above the centerline. The farther the lines are from the centre, the more the momentum.
Height of the histogram – When the histogram is above the centerline, it is to say that the trend is going bullish. Still, when it is below the centerline, it is a bearish trend. When the histogram starts to reduce downwards, it might be giving a sell signal, and when it is increasing upwards, it is a buy signal.
Divergences between lines or histogram with price action – Divergence provides an early signal that a trend might change direction. Divergence occurs when the price makes a higher high, and the MACD line or histogram does not, or when the price makes a lower low, and the MACD line and histogram do not. There might also be a price correction or reversal indicating a shift in momentum and possible exhaustion of a short-term trend in such divergence.
The MACD line can cross above/below the centerline or above/below the signal line multiple times. It might cause many false and tricky signals, especially with volatile assets like cryptocurrencies. A trader should not rely on the MACD indicator alone. It is a valuable tool in identifying market trends and momentum; however, it is not always accurate and can provide misleading signals, especially when there is a weak trend or a sideways price action. To get the best of the MACD indicator, use it alongside other indicators to reduce risks.
Many traders use the MACD indicator with the moving average and price action. Many times when the moving average starts to give a buy signal, the signal is checked with the MACD to see if it provides a corresponding signal (according to the trader’s setup). Let’s take the 50 SMA for example; when the price breaks above the 50 moving average and is starting to signal the start of a bullish trend, such signal could be checked against what signal the MACD is signalling, and with this, the trader might have a reason to enter such trades or wait a little more.
Another way it could be used is when a market breaks out of solid resistance or support. A trader could use the RSI and MACD to check for the market condition, which could be a form of confirmation on whether to enter into such trades or not.
Please note that using MACD and what you look out for in the market strictly depends on the strategy you use. Even though there are similar factors to consider in using the MACD indicator, your trades should only rely on the pattern you have tested over time.
Limitations of the MACD indicator
There are some problems associated with divergence, and they are:
Divergence often signals possible reversal when no reversal happens. It predicts many reversals that do not end up happening.
It doesn’t forecast all reversals
No entry points
It does not give specific entry points, even though it can give a point or signal to take profit.
It cannot be used alone
The MACD indicator, like other indicators, cannot be used alone to get consistent profit. It has to be used with other indicators to get maximum profit.