The Moving Average Convergence Divergence (MACD) technical indicator features an assortment of applications. Developed by Gerald Appel, the MACD indicator has been used extensively for more than 40 years and remains a household name among technical analysts.
The MACD is a customisable indicator primarily used to recognise momentum shifts, identify trend and trend reversal signals, and distinguish between overbought and oversold markets. It can also be employed across a range of asset classes and is utilised by short-term scalpers and day traders, as well as longer-term swing traders and position traders.
What is the MACD Indicator?
The MACD indicator consists of several components, including the MACD line, the Signal Line, and the Histogram.
Unlike the Stochastic Oscillator or the Relative Strength Index (RSI), the MACD is an unbounded indicator. As per Figure 1, the MACD indicator is situated in a lower panel, separated from the price chart (in this case, a candlestick chart). However, some charting platforms permit the indicator to be plotted above.
The MACD Line (marked blue) is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA; it is the difference between these two EMAs. The Signal Line, marked red, is the 9-period EMA of the MACD Line. The MACD Line is the faster moving average, while the Signal Line is the slower moving average. Finally, the MACD Histogram – the vertical bars fluctuating above and below the zero line – is the difference between the MACD and Signal Lines. This 26, 12, 9 format tends to be the default for the MACD indicator.
Interpreting MACD Signals
MACD Crossover:
One of the most popular ways of using the MACD involves the MACD Line and the Signal Line: bullish and bearish crossovers.
Once the MACD Line crosses above (or below) the Signal Line, this indicates an uptrend (downtrend) could be beginning. Traders can buy and sell based on these crossovers; however, it is vital to note that many traders seldom rely on an isolated signal to generate trading decisions. They generally opt for a convergence of signals.
As illustrated in Figure 2, the MACD Line crossed above the Signal Line in October 2023, marking the beginning of a strong upmove. Given that the MACD Histogram is computed by calculating the difference between the MACD and Signal Lines, it should not be surprising that the MACD Histogram registered a zero value at the crossover (more on this later).
MACD Overbought and Oversold Signals
Despite lacking defined boundaries, the MACD can identify overbought and oversold conditions. Experienced traders assess historical extremes to identify these areas. This is similar to locating support and resistance areas on a price chart and extending them to the right, but instead, this is done on the indicator.
In Figure 3, previous extremes were marked using the areas in red (circles) and extended to the right. Aside from an active push higher in April 2024, the highlighted borders have served well as overbought and oversold areas in the past few years. As a result, when price tests these extreme areas, buyers (sellers) could be overheated, and a correction (pullback) in price could materialise.
MACD Divergence
The MACD Divergence signal is a valuable part of the MACD indicator. Like other momentum oscillators, a divergence signal arises when the indicator and price diverge: one trends higher while the other trends lower.
For the MACD indicator, the focus is on the MACD Line. Figure 4 demonstrates a downward trending market, following price forming a top in March 2022 (red circle). Momentum began slowing in the second half of 2022, portrayed through the MACD Line forming a higher low (as you would find in a regular uptrend on a price chart), while price movement established a lower low (as you would find in a standard downtrend). This divergence shows that momentum to the downside is slowing, and a trend reversal may unfold. This is called regular positive divergence, when the indicator leads price action. An example of regular bearish divergence was also seen in 2023, shown through price forming higher highs and the MACD Line failing to follow suit.
MACD Histogram
As already emphasised, the MACD Histogram represents the difference between the MACD Line and the Signal Line. Consequently, traders use the MACD Histogram to estimate MACD crossovers through divergences.
In strong moving markets, the MACD Line and Signal Line diverge. In a strong uptrend, the MACD Line will rise above the Signal Line, for example. However, when upside momentum slows, the MACD Line and Signal Line converge. The MACD Histogram provides an early warning signal of convergence and a possible crossover, as shown in Figure 5. Between February and March 2023, the MACD Line and the Signal Line were diverging and moving lower. At the same time, though, the MACD Histogram was rising, suggesting that the MACD Line and Signal Line may converge and eventually pencil in a bullish crossover.
MACD FAQs
1. What is the MACD?
The MACD, or Moving Average Convergence Divergence, is a well-known technical indicator that helps traders assess trend strength and identify possible turning points in price.
2. How do we interpret MACD signals?
As explained in the article, MACD signals take the form of crossovers, overbought and oversold indications, and divergences to ultimately assess a market’s trend strength.
3. Do traders prefer one signal over another?
Most traders underline the importance of divergence signals at extremes. This means finding divergence signals at overbought and oversold areas.
However, it must be noted that the MACD signals are just that: signals. They do not guarantee that price will do as suggested. This is why back testing trading strategies is vitally important.
