Moving average is a critical indicator used by traders to understand which way the market is moving. It is a simple tool that compares different data points, calculated based on a series of arithmetical means of different subsets of a full data set. It allows the user to get an idea which way the price is moving. When it can help you get a fair understanding of market movement, you need more advanced techniques to understand the magnitude of this change. Hence, MACD or Moving Average Convergence Divergence. It is a momentum oscillator that is often used with other indicators to identify market reversal.
How is MACD measured?
MACD is a moving oscillator. But unlike, other oscillators, it isn’t used to identify when stocks are overbought or oversold. Instead, it is used to understand changing trends in the market. A MACD chart consists of three numbers. Two are line graphs, depicting faster-moving average and slower-moving average respectively. And, a third bar graph that calculates the differences between the two moving average lines.
The line above shows a faster-moving average. And, the blue line is slower-moving average. The green bar depicts the difference between the two lines. It is a trend-following momentum oscillator that shows a relationship between two moving averages of a security price.
MACD is calculated by subtracting Exponential Moving Average or 26-days moving average from 12-days average. The formula is given below.
MACD = 12-Period EMA − 26-Period EMA
(Long-term EMA – Short-term EMA)
EMA stands for Exponential Moving Average gives more weight to recent data, and therefore, more accurate. Nine-day EMA of a MACD is called, ‘signal line’, because buying and selling decisions are based on it. MACD above the signal line indicates buying, and similarly, when MACD crosses below the signal line, it means selling.
How to study a MACD chart
The blue line represents 12-days EMA and red line show 26-days EMA. MACD has a positive value when the blue line is above the red line and a negative when the opposite happens. The distance between MACD and the baseline signifies the growing and converging distances between the EMA lines.
MACD lines are often plotted against a histogram. It shows the distance between the MACD line and the signal line, as shown in the image below. Traders use the histogram chart to identify bullish and bearish movements in the market.
The MACD indicator is slightly different from other momentum oscillator indicators. RSI or Relative Strength Indicator, which is another widely used oscillator indicator, famously shows when a stock is overbought or oversold. While MACD concentrates on signifying difference between two EMAs, RSI measures price oscillation concerning current price highs and lows. Traders often use the two indicators together to base their analysis on trend movement.
Limitations of using MACD
Sometimes results obtained from MACD and RSI may contradict each other. Also, MACD may indicate a trend reversal when no actual reversal happens. These create false positive or negative situations. Traders need to look for confluence between two or more indicators to understand the real market movement.
MACD indicates a trend reversal. When the MACD line lies above the signal line, it shows bullish trends. Conversely, when it falls below the signal line, the market is considered bearish. But it may create too many reversals which don’t occur in reality. These trend reversal indications are more reliable when they conform to the ongoing trend. So, one should not base their strategy solely on the results of MACD; but follow it up with other indicators.