10.10 MACD indicator
What Does Moving Average Convergence Divergence (MACD) mean? It is a mathematical indicator used by some financial traders to predict future price movements of stocks, commodities and other financial instruments. MACD was originally developed by Gerald Appel. The MACD is constructed from two EMAs, or exponential moving averages, derived from the historical price movement of the asset being studied. In a traditional average, all data is treated equally. When calculating an EMA, some data is given higher weight, or importance, than other data. In the case of MACD, the more recent the data, the more importance it is given. An EMA of six, for example, averages the last six values while giving more weight to the most recent ones. MACD subtracts the longer average from the shorter average, and the result is plotted on a chart or graph. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the ‘signal line’, is then plotted on top of the MACD, functioning as a trigger for buy and sell signals. If MACD is greater than zero (refer the figure below), it means the short-term average is higher than the long term average, suggesting an upward trend. Similarly, if MACD is less than zero it suggests that the instrument is trending downwards. The steeper the slope of the MACD plot, the more violently the price is moving and, therefore, the stronger the momentum. Bullish and bearish signals can be generated by crossovers or divergences. A divergence occurs when the MACD indicates a move in one direction while the asset price is moving in the other. A crossover is simply the MACD moving over or under the zero (neutral) point, or alternately, crossing its own target mark. A MACD crossing from positive to negative would be a bearish signal, while a crossover from negative to positive is a bullish signal.
There are three common methods used to interpret the MACD:
As shown in the chart above, when the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell. Conversely, when the MACD rises above the signal line, the indicator gives a bullish signal, which suggests that the price of the asset is likely to experience upward momentum. Many traders wait for a confirmed cross above the signal line before entering into a position to avoid getting 'faked out' or entering into a position too early, as shown by the first arrow.
When the security price diverges from the MACD it signals the end of the current trend.
When the MACD rises dramatically i.e. the shorter moving average pulls away from the longer-term moving average, it is a signal that the security is over-bought and will soon return to normal levels.