MACD stands for Moving Average Convergence Divergence. To understand the meaning behind this name we must first cover the individual parts that make up the MACD indicator.
Firstly, we must input values for two moving averages (see moving averages) one of which is faster, or has a lower period, than the other. Typical values for the periods of these are 26 and 12. There is also a third value we must input into the indicator and that is the signal line. This represents the moving average of the difference between the 26 period and 12 period moving average. The typical value for the signal line is 9, meaning that the previous 9 candles are used to calculate the diversity between the fast and slow moving averages. These three inputs are converted into two lines on the indicator represented on the picture to the right by the red and blue lines. The faster of these two lines (blue) represents the 12-period moving average value minus the 26-period moving average value, at that moment in time - this is the MACD. The slower line (red) represents the 9-period exponential moving average of MACD (the difference between the fast and slow moving averages).
Secondly, we have a histogram represented by the green and red bars on the picture to the right. This histogram measures the gap between the two lines mentioned above (red and blue lines). As these lines spread further apart, the greater the histogram gets. As they move closer together, the smaller the histogram gets. This is where the "convergence" and "divergence" comes into play. As the faster line (blue) comes closer to the slower line (red) it is converging and when it moves away they are diverging. This is better represented visually - see the first image in the gallery at the bottom of this page.
Now we know the make-up of the indicator, how can it be implemented? By comparing moving averages of different periods MACD is attempting to notice any changes in the trend of a particular asset. By using the MACD and it's average, it is attempting to notice this based on smaller, more subtle changes in direction, strength, momentum and volatility. In theory, this makes it more sensitive to change and therefore, able to predict these reversals before other indicators which tend to lag behind price action.
MACD Use Cases
MACD is a trend-following momentum indicator/oscillator. This means that it can be used to assess the direction, strength and volatility of an asset as well as predicting potential changes in these aspects. MACD works best alongside a trending market because it is inherently based on moving averages. During times of consolidation price is erratic and fluctuates. This causes the moving averages to converge and diverge more often, producing false signals.
A buy or sell "signal" can occur when the MACD crosses above or below the zero level. The crossover at zero indicates that there is no divergence between the two moving averages (12-period & 26-period). This crossover can be treated the same as a physical crossover of the moving averages (as described in the moving averages section). A cross above zero is generally treated as bullish and a cross below is treated as bearish.
There are two moving averages within the MACD indicator - the "signal line" and the MACD itself. A buy or sell "signal" can come in the form of a crossover of these lines. Typically, a trader will look for buying opportunities when the MACD crosses above the signal line and selling opportunities when the MACD crosses below the signal line. Crossovers indicate that momentum is about to increase in the direction of the cross over. For example, if the MACD crosses above the signal line it could be said that the trend is likely to accelerate in the bullish direction as the current divergence value has exceeded the average. When a new trend takes place, the MACD will react first and ultimately cross the slower signal line. When this “crossover” happens, the MACD begins to “diverge” moving away from the signal line, repeatedly pointing out that a new trend has formed.
This "crossover" is also indicated by the histogram. It will have a value of zero at the crossover because there is no divergence at the point the two lines meet as they are exactly the same values.
Similarly to the RSI and Stochastic oscillator, MACD can show divergence. Bearish divergence occurs when price makes higher highs however, the MACD indicator shows lower highs. The opposite is true for bullish divergence whereby, price makes lower lows but the MACD indicator shows higher lows.
This form of divergence varies from the RSI and Stochastic indicators in the fact that it relates to the divergence of the two underlying moving averages rather than directly relating to price action. Divergence can occur between the "signal" line, the MACD line and the histogram.
Like any other indicator, MACD can be a powerful tool in every trader's toolbox. However, it should not be used as a standalone system but used in conjunction with other systems in order to improve trading success.
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