Arguably one of the most reliable and most popular momentum indicator used by professional traders is the MACD, which is the abbreviation for Moving Average Convergence Divergence. Its ability to signal loss of momentum when the trend is still high is probably its most preferred feature. The MACD was introduced by Gerald Appel with the purpose of eliminating the ‘lagging-effect’ that is inherent in moving averages (MA). The MACD is a powerful tool that once incorporated into your trading strategy it can generate great entry and exit signals.
The MACD consists of two lines; the MACD line and a trigger or signal line. Besides both lines most software packages also display a histogram which just reflects the difference between the MACD-line and the trigger line. What the MACD does is that it calculates 2 different exponential moving averages and subtracts the ‘slow’ longer period EMA away from the ‘fast’ shorter period EMA. The trigger line is the EMA of the MACD line.
The standard MACD values (which are also advised by Appel) are 9, 12 and 26. Playing around with these values would give the MACD different characteristics that might suit your trading philosophy better. Using shorter input variables make the MACD respond more quickly and likely to generate more cross-over signals, which increases your chances to get in or out of a trade early, but also increases the chance of the MACD generating false signals. Vice versa is the case using higher input variable.
Most novice traders use the MACD to generate entry and exit signals around crossovers between the MACD line and the Trigger line. Actually the real way trader should use the MACD is to identify convergence and divergence with price action. For many of you this is probably the first time you hear about convergence and divergence, yet these are some very powerful signal for a potential continuation or reversal in the market. We speak of convergence when price action is mirrored by the MACD line. It means that momentum is in line with the prevailing trend and signals a continuation of the trend, as shown below:
On the other hand we have divergence. A divergence occurs when the price trend doesn’t agree with the trend of an indicator. So with the MACD it happens when price action is not mirrored by the MACD line. In such case momentum is not in line with the prevailing trend and therefore signals an imminent reversal. Many traders argue that MACD divergence is considered to be the most powerful pattern in trading.
Besides convergence and divergence the MACD also gives other information signals. If the MACD is positive, it means that the short term EMA lies above the longer term EMA. The higher the MACD line, the more short term momentum to the upside it reflects. Once the short term EMA is losing steam against the longer EMA the MACD line will start moving downwards. Once it breaks the trigger line it gives us a signal to look out for. With a break of the trigger line to the upside, it reflects that buyers are dominating the market. On the other hand, a break to the downside reflects market dominance by the sellers.
Since the MACD is built up from moving averages it has a lagging effect in its signals. Some of this lagging effect is countered by the crossing of both lines, but not all of it. The MACD works very well in trending markets, but less when markets are trading. This makes since, since in a trading market the moving averages often lay close to each other, therefore the MACD will be likely to generate a lot of false signals since the MACD line and trigger line move closely together.
Three type of trading signals are generated by the MACD
- MACD line crosses the trigger line
- MACD line crosses zero
- A divergence occurs between price and the MACD
Let’s zoom in on these different type of signals and discuss what they say about market behavior.
MACD line crosses the trigger line
A cross with the trigger line is the most common approach to trading the MACD. A buy signal is generated when the MACD line breaks the signal line to the upside. This we call a bullish crossover and indicates that the price trend is about to accelerate upwards. A sell signal when the MACD crosses the trigger line to the downside, which is called a bearish crossover.
The histogram that most software packages show helps in quickly spotting the difference between the MACD and trigger line. A narrowing histogram suggests that a crossover may be at hand, while a widening histogram suggests that the ongoing trend is getting stronger.
MACD line is crosses zero
A cross of the MACD line up through zero is considered a bullish signal. A cross of the MACD line down through zero, a bearish signal. A crossing through zero happens when there is no difference between the fast and the slow EMA. Such crossings provide some evidence of a change in trend direction but are not as strong as a cross with the trigger line.
A bullish center-line crossover occurs when the MACD line goes through the zero line. This happens when the ‘fast’ EMA > ‘slow’ EMA. A bearish center-line crossover occurs when the MACD line moves below zero. This happens when the ‘fast’ EMA < ‘slow’ EMA. How long it takes before another center-line crossover occurs depends on the strength of the trend. As long as there is a strong trend there will be no crossover anytime soon.
A divergence occurs between price and the MACD
This powerful trading signal has already been discussed briefly. But since it is considered so powerful we will pay some extra attention to the dynamics of it.
A Positive Divergence or Bullish Divergence forms when price records a lower low, while the MACD forms a higher low. The new lower low in price affirms the current downtrend, but the higher low set on the MACD indictor shows that momentum to the downside is shifting. This is a bullish signal which suggests that the downtrend might be over soon. But keep in mind that despite less downside momentum, as long as the MACD is in negative territory the downside momentum is still outpacing upside momentum.
Negative Divergence or Bearish Divergence happens when price makes a new high, but the MACD does not move up as high as the previous move up. A bearish divergence can often be found in a strong uptrend. The uptrend often starts with a strong surge in upside momentum (MACD). When trend continues moving up, it likely continues at a slower pace that causes the MACD to decline from its highs. Like with the Bullish Divergence, upside momentum may not be as strong, but as long as the MACD is still in positive territory, upside momentum is outpacing downside momentum. The opposite often occurs at the beginning of a strong downtrend.
Trend strength and the MACD
So in summary
When the trend is up
- If the MACD line stays above the zero line when a retrace in trend occurs, consider the trend to be strong.
- If the MACD line returns to the zero line or goes below when the market retraces, consider the trend to be weak
When the trend is down
- If the MACD line holds below the zero line on the retrace in the trend, consider the trend to be strong
- If the MACD line returns to the zero line or even goes above it when the market retraces, consider the trend to be weak
Like any indicator the MACD can also generate false signals. A false positive signal for example occurs when there is a bullish crossover followed by a sudden decline in price. A false negative signal would be the other way around. It is therefore advisable to apply a filter to the signal-line crossovers to ensure that they will hold. An example would be a price filter that would only buy if the MACD line breaks above the signal line and remains there for at least three timeperiods. Of course such a filter comes with a tradeoff. It will decrease the amount of false signals, but on the contrary it increases the frequency of missed profits.
The MACD indicator is a great indicator since it brings momentum and trend together in one indicator. Most people misuse the indicator and try to find levels of overbought and oversold. The MACD is not a suitable indicator for such. Better use the RSI oscillator for such for example.