Moving Average Convergence and Divergence (MACD)
Now that we fully comprehend the concept of divergence. Let's discuss (MACD) indicator.
What is a MACD indicator and what can it reveal?
Moving Average Convergence Divergence (MACD) is a technical analysis indicator which basically measures the distance between two moving lines. MACD is that type of indicator which is a hybrid of trend following indicator and trend identifying indicator.
How is MACD calculated?
The MACD comprises of two lines. Fast line and the slow or signal line. Slow line is easy to identify as it will be smoother than the fast line.
Step1. Calculate a 12-period exponential moving average of the close price.
Step2. Calculate a 26-period exponential moving average of the close price.
Step3. Subtract the 26 period moving averages from the 12-period moving average. This is the fast MACD line.
Step4. Calculate a 9-period exponential moving average of the fast MACD line calculated above. This is the slow or signal MACD line.
Uses of MACD indicator:
MACD generates signals from three main sources:
- Moving average crossover
- Centerline crossover
Crossover of fast and slow lines
The MACD proves most effective signals in wide-swinging trading markets. We will first consider the use of the two MACD lines. The signals to go long or short are provided by a crossing of the fast and slow lines. The basic MACD trading rules are as follows:
- Go long when the fast line crosses above the slow line.
- Go short when the fast line crosses below the slow line.
These signals are best when they occur some distance above or below the reference line. If the lines remain near the reference line for an extended period as usually occurs in a sideways market, then the signals should be ignored.
Center line crossover
A bullish centerline crossover occurs when MACD moves above the zero line and into positive territory. This is a clear indication that momentum has changed from negative to positive or from bearish to bullish. After a positive divergence and bullish moving average crossover, the centerline crossover can act as a confirmation signal. Of the three signals, moving average crossover is probably the second most common signal.
A bearish centerline crossover occurs when MACD moves below zero and into negative territory. This is a clear indication that momentum has changed from positive to negative or from bullish to bearish. The centerline crossover can act as an independent signal, or confirm prior signal such as a moving average crossover or negative divergence. Once MACD crosses into negative territory, momentum, for the short term, is expected to be bearish.
An indication that, an end to the current trend may be near occurs when the MACD diverges from the security. A positive divergence occurs when MACD begins to advance and the security is still in a downtrend and makes a lower reaction low. MACD can either form as a series of higher lows or a second low that is higher than the previous low. Positive divergences are probably the least common of the three signals, but are usually the most reliable and lead to the biggest moves.
A negative divergence forms when the security advances or moves sideways and MACD declines. The negative divergence in MACD can take the form of either a lower high or a straight decline. Negative divergences are probably the least common of the three signals, but are usually the most reliable and can warn of an impending peak.