Studying Market Trend Using MACD Oscillator (MACD)

The MACD is widely used in trend trading. However, unlike typical oscillators, MACD isn’t used for discovering overbought or oversold situations. Instead, MACD measures momentum or trend strength and studied against the signal line to trigger trading signals.   

The line oscillator gives trading signals like the two-line moving average system. It shows a relationship between two moving averages of a security price, calculated over different durations. MACD involves calculating the difference between the fast-moving 12-period moving average and 26-period moving average. The resultant is a MACD line. A nine-day EMA (exponential moving average) is then plotted on the chart against the MACD line, called the signal line, to indicate trading signals. In the late seventies, Gerald Appeal introduced the concept of MACD.  

How Does The Indicator Work?

MACD turns two-moving lines into a momentum oscillator. It offers the best of both worlds – trend following and momentum. It is a simple tool that compares different data points, calculated based on a series of arithmetic means.  While trading based on technical charts, it is crucial to find the trend because it is where the most money can be made. 

In the chart, MACD oscillates around the ‘zero’ line, crosses over or below it reflecting moving average convergence, divergence, and crossover. But since MACD is unbounded, it isn’t exactly useful in identifying overbought and oversold levels. Traders study the chart for signal line crossovers, centreline crossovers, and divergences for trading signals.    

The calculation of MACD involves measuring 12-days, 26-days, and nine days moving average, considering the closing price of the stock over the period. The fast-moving average line or 12-days MA is responsible for greater oscillation in calculating MACD. The long moving average is less reactive to the price change of the underlying security. Divergence occurs when the MAs move away from each other. 

The MACD line crossing above the ‘zero’ line is an indication that upside movement is occurring. As the line diverges away from the centreline, the upward thrust gains momentum. Conversely, MACD crossing below the ‘zero’ line signifies the downward movement in the market.

The Formula 

MACD uses a simple formula. It is the difference between 12-days and 26-days exponential moving average.

MACD= (12-days EMA – 26-days EMA)

Signal line= 9-day EMA of MACD 

MACD Histogram= MACD – Signal line 

 MACD line, signal line, and MACD histogram, together are used for studying trend strength. The 9-day signal line works like a cursor, to identify turns. The histogram is the difference in value between the MACD and the signal line. So when the histogram is positive, the MACD line is above the signal line, indicating an uptrend. The opposite happens when the histogram shows a negative value.   

Including MACD Oscillator In Trading Strategy

MACD oscillator offers a visual representation of when the trend is changing. MACD signal line crossover is the most common indication used by traders to identify a bullish or bearish trend. The signal line trails MACD and makes it easier to spot a turn.  A bullish crossover happens when the MACD line crosses the signal line from below. Similarly, chartists record a bearish crossover when MACD line crosses below the signal line. When it happens, a crossover lasts for few days to few weeks.

It is important to learn to use MACD trend identifying oscillator in your trading strategy. Here is why,

– It is a simple trading indicator that can offer accurate trading signals

– Sometimes MACD offer trend reversal signals in advance 

– The 9-day EMA further smooths out the noise 

– MACD offers additional signal regarding trend strength 

– It offers updated signals compared to moving average  

However, while using MACD in your trading strategy, the caveat remains the same as for other charting tools. 

One main problem with MACD oscillator is that it shows too many crossovers, which adds to the confusion. The MACD line can cross the signal line even without an actual reversal happening – causing a situation called false positive. On the other hand, it also lacks in forecasting all reversals. To say it, MACD oscillator indicates too many reversals that don’t occur and not enough reversals that happen.  

The crossover happens even when there is only sideways movement in stock price. But the MACD chart will show a false positive. Traders need to wait out to see if the crossover is an actual change in trend or a false reversal. In case of a false reversal, the MACD line will eventually fall back to the zero line.

Therefore, traders study MACD oscillator along with other charting tools to confirm a reversal. Another pitfall is signal line crossovers at positive or negative extremes. It takes significant movement in underlying stock volume to push momentum to an extreme. Chartists use historical data to confirm the validity of such extremities.     

Conclusion 

MACD is a unique tool. Unlike other oscillators, it performs the dual role of an oscillator and crossover indicator. It brings together momentum and trend, which one can apply to daily, weekly, or monthly charts. However, MACD also comes with a set of limitations.  It often signals too many reversals which don’t occur in reality. To avoid the problem it is common for chartists to use MACD histogram to confirm trend reversal. Be mindful of reckoning both its strengths and limitations while applying the oscillator in your trading strategy.