Moving Average Convergence Divergence (MACD) in Stock Trading: A Comprehensive Guide

On the surface, the Moving Average Convergence Divergence (MACD) is a technical indicator that could sound intimidating to many traders. Yet, beneath its seemingly complex calculations lies a powerful tool for understanding market momentum and identifying potential turning points. This comprehensive guide will peel back the layers of the MACD indicator. It will reveal its inner workings and equip you with the knowledge to use its insights for informed trading decisions.

What is a MACD indicator?

MACD is a trend-following momentum technical indicator that shows the relationship between two moving averages of a security’s price. The standard is the brainchild of Gerald Appel and debuted in stock trading in the late 1970s. It has since become a standard analysis tool for many stock traders.

The metric consists of three key components:

1. MACD Line: This represents the difference between the 12-period and 26-period Exponential Moving Averages (EMAs) of the closing price.
2. Signal Line: This is a 9-period EMA of the MACD line, acting as a smoother indicator of potential trend changes.
3. MACD Histogram: These coloured bars above and below the zero line depict the momentum of the price movement. 

Here’s a representation of the three parts:

Using MACD in Stock Trading 

Now that we understand how the MACD works, let’s explore how to translate its insights into practical decisions for the stock market.

Here’s how you can interpret its signals:

Trend Identification using Crossover Signals

Crossovers occur when the MACD line crosses above or below the signal line. There are two types of crossover signals:

• Bullish MACD Crossover: The MACD line crosses above the signal line from below. This movement implies the short-term moving average (MA) is rising faster than the long-term MA; thus, the stock’s price is gaining upward momentum, and a possible uptrend is emerging. You can interpret these crossovers as buy signals or signs to exit short positions.
• Bearish MACD Crossover: The MACD line crosses below the signal line from above. That suggests that the short-term MA is falling faster than the long-term one. Consequently, the price is losing momentum, and a possible downtrend is emerging. You can use it as a signal to sell or exit long positions.

The following diagram shows how to interpret crossover signals.

When the MACD line crosses above the signal line from below at point A, as indicated in the image, it signals an impending bullish trend. Shortly afterward, as demonstrated in the image, a bullish trend emerges. This suggests that it may be an opportune time to consider either buying or exiting short orders.

Conversely, at point B, when the MACD line crosses below the signal line from above, it signals a bearish trend. Shortly after, the market transitions to a bearish phase, presenting an opportunity for selling or closing long positions.

Trend Reversals using MACD Divergence

Divergence occurs when the Moving Average Convergence Divergence line and the price move in opposite directions. It indicates potential trend reversal and takes two forms:

• Bullish Divergence: This scenario happens when the MACD line makes a higher low while the price makes a lower low. It indicates that the downward momentum of the price is weakening, and a possible uptrend reversal is forming. It acts as a buy or entry signal for a long position.

• Bearish Divergence: Arises when the MACD line makes a lower high while the price makes a higher high. It implies that the upward momentum of the price is weakening, and a possible downtrend reversal is forming. A bearish MACD divergence can be your sell or an exit signal for your long positions.

Momentum Assessment

i) Positive Histogram Bars:

When the histogram bars are above the zero line, it indicates that the MACD line is above the Signal line, suggesting bullish momentum. The taller the bars, the stronger the bullish momentum. When these histogram bars get smaller, it suggests a potential weakening of the bullish trend, signalling a possible reversal or a slowdown in the bullish momentum.

ii) Negative Histogram Bars:

When the bars are below the zero line, it signals that the MACD line is below the Signal line, indicating bearish momentum. The taller the bars, the stronger the bearish momentum. When these histogram bars get smaller, it signals a potential weakening of the bearish trend. As a trader, you might want to be prepared for a possible reversal or a slowdown in the bearish momentum.

Moving Average Convergence Divergence Calculation

Calculating the MACD is a straightforward process primarily focussing on the relationship between two exponential moving averages (EMAs). Let’s break that down here:

1. Choose Your Timeframe: Decide the timeframe for the calculations.  Typically, the standard periods used for MACD calculations are 12, 26, and 9. These represent the periods for the short-term EMA, the long-term EMA, and the Signal Line EMA, respectively.

2. Calculate the Short-Term EMA: Use the Exponential Moving Average (EMA) formula with a period of 12, giving more weight to recent prices. The formula for EMA is:

     *EMA(t) = (Price(t) * multiplier) + [EMA(t-1) * (1 – multiplier)]*

     Where multiplier = 2 / (1 + Number of Periods)

Note that many charting software automatically calculates EMAs, so you might not need to do this manually.

3. Calculate the Long-Term EMA: Repeat the above process for the long-term EMA, using a longer time (e.g., 26 days).

4. Find the MACD Line: Subtract the long-term EMA from the short-term EMA to obtain the MACD Line:

     MACD Line = 12-day EMA – 26-day EMA

5. Calculate the Signal Line (9-day EMA of MACD Line): Apply the EMA formula again, but this time use the MACD values instead of closing prices and a period of 9:

Signal Line = EMA(MACD, 9)

6. Calculate the MACD Histogram: The Histogram represents the difference between the MACD and Signal Line. Subtract the Signal Line from the MACD Line:

MACD Histogram = MACD – Signal Line

There! You’ve calculated the Moving Average Convergence Divergence and its components. Now you can use them to analyze trends, momentum, and potential turning points in the market.

Limitations of MACD

Like any technical indicator, MACD has its limitations. It’s not a crystal ball, and relying solely on its signals can lead to missed opportunities or even losses. Here are some things to remember:

• False Signals: MACD can sometimes cross the signal or zero lines without indicating a real trend change or reversal. This can lead to losses and frustration, especially if you base your trading on MACD crossovers alone.
• Lagging Indicator: The MACD is a lagging indicator, meaning it reacts to past price movements. This can be beneficial for confirming trends. But it might not be ideal for catching quick price changes, i.e. the best timing for entering or exiting trades.
• Over-reliance Trap: The danger of overly relying on the MACD indicator can lead to poor decision-making. To avert this danger, consider adopting a balanced trading strategy that combines multiple indicators and market factors.

Conclusion

The Moving Average Convergence Divergence (MACD) is a versatile and popular tool among traders. Its ability to identify potential buy and sell signals can be an invaluable part of any trading strategy. However, like any tool, it’s important to use it with other indicators and tools to confirm signals and avoid potential false positives.

FAQ

How do I read and interpret the MACD indicator?

To read and interpret the MACD indicator, one should analyze crossovers, divergences, and trends in the histogram. A bullish crossover signals potential upward momentum, while bearish crossovers indicate a downward momentum. Divergence unveils potential trend reversals, and the size of the histogram bars signals the strength of the momentum.

What is a good MACD level?

There isn’t a universal  “good” or “bad” level for the MACD. Instead, you should look for changes in the direction of the MACD line, signal line and histogram to identify potential buy and sell signals.

What’s the best trading strategy for the MACD indicator?

The best strategy depends on your risk tolerance and trading objectives. Simple strategies like crossovers and divergences are suitable for beginners. Intermediate and advanced traders may explore swing trading, position trading, day trading, or scalping using MACD.

What’s the best time frame for MACD indicator?

The optimal time frame depends on your trading style. Shorter time frames (e.g., 15 minutes) suit day traders, while longer time frames (e.g., daily or weekly) are suitable for swing or position traders. Experiment with different time frames to find what aligns with your strategy.

How do I use MACD in trading view?

To use the MACD indicator in TradingView, click the “Indicators” button at the top of the screen, then type “MACD” in the search box. Click the “MACD” option to add the indicator to your chart. You can then customize the settings to your liking.