MACD Indicator

MACD indicator is an abbreviation of Moving Average Convergence Divergence indicator. It is a technical indicator created by Gerald Appel in the late 1970s. Thomas Aspray improved it by adding a signal line in 1986.

It is a lagging indicator. It helps to analyze the change of rate of price movement, the direction to which a share price is moving. It also helps to determine the strength of the stock market.

Construction
MACD is created by computing the difference between the two exponential moving averages (EMA). Closing price is used for the calculations. It is calculated by subtracting the value of a 26 period exponential moving average from a 12 period exponential moving average. This difference is shown as a line chart or a histogram.

A 9 period exponential moving average of this MACD indicator is displayed as the signal line.

Exponential moving averages gives more weight for the recent price action. So the difference in the EMAs represent the trend as well as the momentum of the stock price action.

Since it is based on absolute prices and not on percentage, it is an unlimited indicator or elastic indicator. The numbers goes beyond 100. Therefore there is no overbought and oversold zones.


macd indicator, macd, moving average convergence divergence, lagging indicators, technical indicators




Compare the above MACD Line chart with the MACD Histogram given below.


macd indicator, macd, moving average convergence divergence, lagging indicators, technical indicators





Trade Signal
Moving Average Convergence Divergence indicator can give three types of trade signals, which are helpful in profitable stock trading.


1. MACD / Signal Line Crossover
MACD crossing over the signal line offers a trade signal.

So, when ever the MACD crosses above this signal line it is a buy signal. It is called bullish crossover. This indicates that the trend is taking its momentum in the upward direction.

When ever the MACD crosses below the signal line it is a sell signal. It is called bearish crossover. This indicates that the trend is taking its momentum in the downward direction.

2. MACD / Zero Line Crossover
If the MACD crosses above zero line, it shows the strength of the stock. If it is crosses below zero line, it shows the weakness of the stock.

3. Divergence
Divergence gives an early clue to the major change in the trend of the stock under study.

At the end of the down trend, the price of a stock makes a lower low swing. But the MACD makes a higher low swing. This is because of the subtle shift in the rate of change of momentum. This is called positive divergence or bullish divergence. It indicates that the down trend is at its end. You can prepare yourself to go long.

Conversely, at the end of an up trend, the price of a stock makes a higher high swing. But the MACD makes a lower high swing, recording the shift in the rate of change of momentum. This is called negative divergence or bearish divergence. It indicates that the up trend is at its end. You can prepare yourself to go short or at least get out of a long position.

macd indicator, macd, moving average convergence divergence, lagging indicators, technical indicators




Compare the bullish divergence of MACD indicator in the above chart, with the bearish divergence signal in the chart below.

Both belong to FTSE 100.


macd indicator, macd, moving average convergence divergence, lagging indicators, technical indicators



False Signals
Like any technical indicator, MACD indicator also gives false trade signals. This is because it's computation is based on moving averages. Though the prices are making higher highs, the indicator can give a sell signal in during a correction.

Similarly, in a bear trend the indicator can give a buy signal during a rally.

This false signals can be taken care

  • By entering the market after waiting for 2 to 3 time periods.
    This will delay the trade entry. It increases the stop loss and affects the risk to reward ratio, there by eroding the profit.
  • By entering above a minor swing high.
    This gives clear entry and exit levels. But affects risk to reward ration and the profit.
  • By taking only buy signals in a bull trend and only sell signals in a bear trend.
    Even this method sometimes gives whip saws.


Do not make trading decisions based on any one indicator alone. Any indicator works better when the commodities are moving in an up trend or in a down trend.





Click here to go back from MACD Indicator to Stock Trading Technical Indicators.

Click here to go back to Stock Trading Infocentre Home page.


| Privacy Policy | Disclaimer | Contact Me | Site Map |



New! Comments

Have your say about what you just read! Leave me a comment in the box below.