MOVING AVERAGE CONVERGENCE DIVERGENCE
The moving average convergence divergence, or MACD, is a popular technical indicator used by traders in all sorts of markets. The name comes from the fact that it is composed of two moving averages, one is typically a 12-day exponential moving average and the other is 26-day exponential moving average. Since the 12-day average reflects changes faster than the 26-day average, you can see whether the average price over the past 12 days exceeds or falls below the average price over the past 26 days, which would indicate that some kind of trend is developing.
The blue and red lines at the bottom of the figure below are the 12-day and 26-day EMA of the MACD. When the blue line falls below the red line, there is a downtrend. When the blue line rises above the red line, there is an uptrend. This is because the 12-day EMA reflects changes more quickly because it reflects the more recent data. The value that results from subtracting the 26-day EMA from the 12-day EMA is called the MACD Line. This value reflects the space between the blue and red lines.
A 9-day EMA of this MACD Line is called the Signal Line. The MACD Line itself is subtracted from the Signal Line to give the histogram that is generally plotted underneath the lines of the 12- and 26-day EMA. When the histogram shows positive values, it is a bullish signal. When the histogram is in the negative, it is a bearish signal. These signals are not very useful in and of themselves but are good for confirming other signals. But the MACD indicator does identify that trends are underway.
If you ever see “MACD (12, 26, 9)” in your trading platform, you will know what these stand for. These values represent the parameters supplied to the MACD indicator. These can be changed on most platforms and some who seek greater sensitivity use the parameters “5, 35, 5”, but the typical “12, 26, 9” parameters are so widely used and standard that most traders do not change them and it is not recommended for beginners to change them at all.
One of the more powerful uses of the MACD is through the identification of bullish divergences or bearish divergences. When the market makes a higher high, but the corresponding MACD from that time frame moves downward or stays constant, this is a bearish divergence and is indicative of a reversal downward. When the market makes a lower low, but the corresponding MACD from that time frame moves upward or stays constant, this is a bullish divergence and a sign that the market is about to reverse in the positive direction. Here is an example of a bullish divergence from July 2017 which illustrates how a MACD divergence can be used to predict an upward move.
How to Find Entry, Exit Points for MACD Divergence Trades
The MACD is extremely useful for finding points of reversal in the market, but many traders run into problems trading them for two reasons:
- MACD divergence is typically a long-term strategy. Those who enter the market expecting to take their profits and get out quickly are usually disappointed and are scared away by the pullbacks.
- Since MACD divergences are based on moving averages, there is no simple way to calculate price targets or risk/reward ratios from its output. This makes setting these values very difficult.
One way to resolve the difficulty in inferring a price target from the MACD histogram is to use the MACD histogram for your entries and exits. That is, if the MACD exceeded the extreme where the divergence was first seen, it would be a sign that the market has moved against the trade and could be cause for closing the position.
Other MACD Tricks
The MACD is generally at its most useful in non-trending markets. In a ranging market, where the trend flips back and forth, the MACD histogram shows the current trend and its intensity. The MACD can be used in other ways, however.
When the MACD histogram is very negative, it can indicate that the market is oversold. This is a buy signal. Conversely, an extremely positive MACD histogram suggests a sell signal. Admittedly, MACD is not well suited to determining whether a market is overbought or oversold. But this can be used to add credence to and confirm other signals.
The MACD can also be used to confirm trends. If the MACD converges with the market, that is, if the MACD shows a rise when the market does, this is considered a confirmation of the trend by the MACD indicator. This does not verify that the trend will continue or that it is time to enter a trade in and of itself. It simply means that the trend is strong and the MACD provides another argument in favor of the trend continuing.
The MACD indicator is like a Swiss army knife of technical indicators because it combines momentum and trend in a single indicator. Caution should be exercised in its use, as strong uptrends can sometimes generate bearish divergences. But such divergences in combination with other bearish signals should be respected.