What is MACD and how does it work?
MACD (moving average convergence/divergence) is an indicator developed by Gerald Appel in the late 1970s for technical analysis of stock prices. It highlights changes in the strength, direction, momentum, and duration of a stock price trend.
The MACD indicator comprises three-time series (most often the closing price) that are calculated using historical price data. These three series are the MACD series itself, the "signal" or "average" series, and the difference between the two, the "divergence" series. The MACD is basically a difference between a "fast" (short period) and a "slow" (longer period) exponential moving average (EMA) of the price series. The average series is a moving average of the MACD series.
Exponential moving averages highlight recent changes in the price of a stock. The MACD series measures changes in a stock's trend by comparing EMAs of different lengths. It is claimed that the difference between the MACD series and its average reveals major shifts in the direction of a stock's trend. It may be required to correlate MACD signals to indicators such as RSI power.
The MACD and average series are displayed as continuous lines in a plot whose horizontal axis is time. In contrast, the divergence is shown as a histogram.
A fast EMA responds faster than a slow EMA to recent changes in a stock's price. If you compare EMAs of different periods, the MACD series will indicate changes in the trend of a stock. It is said that the divergence series can disclose subtle shifts in the stock's trend.
MACD is based on moving averages, that's makes it a lagging indicator. As a future metric of price trends, the MACD is less useful for stocks that are not trending in a range or are trading with unpredictable price action. Hence the trends will already be completed or almost done by the time MACD shows the trend.
How does MACD work?
MACD is a momentum oscillator that is mostly used for trading trends. Even though it is an oscillator, it is not used to detect overbought or oversold market situations. On the chart, it appears as two lines that oscillate together without boundaries. The crossover of the two lines results in trading signals similar to a two-moving-average system.
When the MACD crosses above zero it is considered to be bullish, while crossing below zero is considered bearish. Additionally , when the MACD moves from a low of zero, it is considered bullish. It is considered bearish when it turns from above zero.
The indicator is considered bullish when the MACD line crosses from below to above the signal line. The greater the distance below the zero line, the stronger the signal is.
MACD is considered bearish when the MACD line crosses from above to below the signal line. The greater the distance above the zero line, the stronger the signal is.
The MACD will whipsaw throughout trading ranges, with the fast line crossing back and forth over the signal line. To reduce portfolio volatility, traders using MACD generally avoid trading in this situation or close positions.
When the divergence between the price action and MACD confirms the crossover signals, it is a stronger signal.