The MACD: The Perfect All In One Indicator?

What is the MACD Stock Chart Indicator

Expert traders are fast to let you know that combining two indicators will inevitably give you better and more reliable signals on when to enter or exit an open position. Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship in the movement of the price of a security. It combines two indicators; a 12-day exponential moving average for the short-term changes and a 26-day exponential moving average for the long-term changes.

The MACD was invented by Gerald Appel in the 1970s, where his intention was to create an indicator that will reveal, direction, momentum, strength, and length of a stock's trend. This makes it unique compared to other indicators, as it's really an "all in one" indicator. 

The MACD Formula

The calculation of MACD is done by taking the 26- period exponential moving average (EMA) and then minus 12-period EMA. This gives a 9 day EMA of the MACD referred to as the signal line. 

When the 12-period EMA is above the 26-period EMA, the MACD will be a positive value. The MACD will be a negative value when the 12-period EMA is below the 26-period EMA. When the distance between the MACD and baseline, increases, it indicates that there is a growing distance between the two EMAs.

MACD = 12-period EMA – 26-period EMA

Signal Line= 9-day EMA of MACD

Histogram = MACD Line - Signal Line

The chart below breaks down the three aspects of the MACD indicator.
  
MACD histagram signal line breakdown

When the MACD crosses above its signal line, this indicates that a trader is in a position to buy the security and while when the MACD crosses below its signal line, it’s an indication to sell or short the security (selling short is not advised beware).

MACD's data can be represented with a histogram, which maps the distance between the MACD and its signal line. The histogram will be above the MACD's baseline when the MACD is above the signal line and vice versa. The MACD histograms are used by traders to identify when the bullish and bearish momentum is high.


MACD Indicator Interpretations

The MACD is designed to focus on the convergence and divergence of its two moving averages.
Where divergence happens when the moving averages go in opposite directions, while Convergence occurs when the moving averages move closer to each other. This is the foundation of how buy and sell signals are generated using the MACD Indicator.

Below, are a few easy-to-understand signals generated by the MACD. Keep in mind this is a basic interpretation and as you practice and continue to read more material you can have much more advanced readings, which will reduce false signals.

  • When the MACD line crosses above zero, it indicates a bullish trend while a bearish trend will be indicated by the MACD crossing below zero.
  • When the MACD line crosses the baseline back and forth, MACD traders will avoid the market to deal with minimal portfolio volatility. If you see this you should really stay away from buying options, as it shows no clear trend.
  • A stronger signal is indicated when the divergence between the MACD and the price action is in line with the crossover signals.
You can see a breakdown of the basic interpretation in the chart below. Please note that this indicator is lagging, so it's quite hard to use as a way to predict future price movement. It's really about riding the wave of momentum.

MACD crossover buy signal bullish bearish


MACD Bullish Divergence and Bearish Divergence

When the momentum of a security price is waning, a divergence indicator is meant to correctly show that a reversal is imminent. When an indicator makes lower highs while the price is making higher highs, this is called a Bearish Divergence. While when the price is making lower lows and the indicator makes higher lows, this is referred to as a Bullish Divergence. Divergence is one of the most powerful aspects of this indicator.

You can measure divergence via the histogram as well as the signal line. You can even draw support and resistance lines on this indicator as well (they may even be more meaningful than drawing it on just pure price charts). 

Take a look at the example below, which shows a bullish reversal using divergence. In this example, the histogram never made a lower low, but the price did. Eventually, the MACD's bullish divergence signals correctly foreshadowed price making new highs shortly after. Note, I added a horizontal line at 0, to indicate the when Bulls and Bears are in control (just a bit more pleasing on the eye).

bullish macd histogram reversal price

Conclusion

The MACD indicator is commonly used by traders to detect when the current momentum in a stock’s price may indicate a change of its underlying trend. It is also important to note that since the indicator uses historical data, it can be referred to as a lagging indicator and will reverse course after a change in the price action has taken place. Therefore it's important to note this severe limitation and possibly use other indicators/signals to exit your position. Although it was meant to be a multi-use indicator whether several different parts, I think it really falls short on its own but can be used in conjunction with other indicators to develop a more concrete trading system, where it will allow you to ignore a lot of the false signals the MACD indicator tends to generate.

In my experience, it's best to use the MACD as a trend riding signal, where you want to capture a strong trend for a brief amount of time. Remember, it's not good and letting you know when it's time to exit, unless you interpret histogram shrinking as an exit-entry (basically as the histogram Y-axis shrinks).

One of the best ways to create a trading system is to scan the market each day where you find stocks that have their MACD line cross above the signal line (bullish buy signal). You can further backtest this strategy and continually add further refinements until you have something close to beating the buy-and-hold strategy. This is a great starting point for creating a trading system. For those looking for a world-class scanner and backtesting tool, I highly recommend signing up for TrendSpider (they have a 7-day free trial), and use the code 'CL25' for 25% off!

For those interested in other indicators please check out The Stochastic Oscillator.


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