What is Moving Average Convergence Divergence (MACD)? What is its Significance in Stock Exchange?

What is MACD?

Moving Average Convergence Divergence is a momentum oscillator that measures the strength of an uptrend or downtrend. It's calculated by subtracting two moving averages, one for long-term trends and another for short-term trends. The MACD line will cross above zero when there are more upward than downward movements in price over time. When it crosses below zero, this indicates a reversal from up to downtrend. This indicator can be used as a leading indicator because it signals future changes before they occur.

The MACD Line

A simple Moving average calculation is performed on prices over some period of time. Then, we make the difference between those MA values and plot them into a graph. 

 We then add these lines together at different points along their length. These lines represent how much each value has moved relative to its previous value. If you look closely, you'll notice that the first line represents the most recent data point while the second line represents the least recent data point. In other words, if the blue line moves higher than the red line, it means that the current price is greater than the last price. 

If the green line rises faster than the black line, it shows that the market is currently trending upwards. Conversely, if the green line falls slower than the black line, it shows that the market may be heading downwards.

Signal Lines: Signal lines show whether the market is likely to move up or down based on historical performance. They're usually plotted with a positive slope, which means that the market tends to rise after crossing the line. However, sometimes the signal line slopes negatively, meaning that the market tends to fall after crossing the line. For example, suppose that the market was rising steadily until yesterday, but today crossed below the signal line. That would indicate that the market could soon begin falling again.

Crosses: Crosses mark significant turning points in the market. You should pay close attention to any crosses that appear near your entry-level. If the market begins to turn around just prior to entering a trade, you might want to wait longer before placing a stop-loss order.

Stops: Stops help protect against losses. By setting stops low enough so that you don't lose money during normal trading conditions, you ensure that you won't get hurt too badly if things go wrong. Setting stops high ensures that you make less profit during good times.

Benefits of MACD MACD Fast Crossovers

1.      It Provides early warning signs of potential reversals.

2.      Can predict where the next major support/resistance levels lie.

3.      It is useful for identifying divergences.

4.      It has been shown to work well together with other indicators such as RSI, Bollinger Bands, etc.

How To Use MACD Indicator?

To use the MACD indicator effectively, you need to know what type of chart pattern you're looking for. There are three types of charts that have historically provided strong evidence of a change in direction:

Bullish Engulfing Pattern: This occurs when the MACD line starts out negative and becomes increasingly bullish throughout the duration of the pattern.

 MACD / EMA

Calculate the signal line and then subtract it from the moving average.

SignalLine ClosePrice + MACD * SMA_Length

Signalsubtract SignalLine - EMA *SMA_length

Example: The following image illustrates an engulfing bull breakout. Notice how the MACD line started off negative, became more bullish, and eventually turned upward.

Bearish Engulfing Pattern: Similar to the bullish engulfing pattern, this one happens when the MACD line turns bearish and remains consistently lower than the moving averages. It's important to note that there can also be false breakouts within a trend. In these cases, the price will reverse back into its original range without actually breaking away from the previous trend.

 MACD Line Below Moving Averages

The MACD line has become significantly weaker than both the 20-day and 50-day moving averages.

 Bullish Head & Shoulders Pattern: When the MACD line breaks above the moving averages, it indicates that the current uptrend is about to end. At this point, traders may consider exiting their long positions while they still have some upside left.

MACD Signaling Bearish Trend Change

Notice how the MACD line broke beneath the moving averages. Traders who needed a continuation of the recent rally now believe that the downtrend is over. MACD Histogram

A histogram shows the distribution of prices relative to the MACD line. As the MACD line moves higher, the number of bars at each price increases. Conversely, as the MACD line falls, fewer bars exist at each price.

 MACD Slow Crossover

In addition to being used as a momentum oscillator, the MACD line can also serve as a slow crossover indicator. If the MACD line passes below the zero level, it signals that the market is entering a new period of weakness.

MACD Crosses Above Zero Level

When the MACD line crosses above 0, it signifies that the market is beginning to enter a new upswing.

If the MACD line crosses through the center of the histogram, it means that the market is experiencing fast crossovers between periods of strength and weakness. These fast crossovers occur because the MACD line is crossing either side of the histogram very quickly.

 MACD Stochastic Oscillators

Stochastics indicate volatility by comparing two different timeframes. They provide additional information on whether or not the market is trending or trading sideways.

Limitations of MACD

Although the MACD line provides useful insight for technical analysis, it does come with several limitations:

There are no regulations regarding what constitutes a valid trade setup. Some people use the MACD line in conjunction with other indicators such as stochastics, RSI, etc., but others don't bother using any tools besides the MACD line itself.

Although the MACD line is often considered a momentum oscillator, it doesn't always work well during trends. For example, if you're looking at an upward sloping chart where the price is rising steadily, then the MACD line should move upwards along with the price. However, if the price starts falling after reaching resistance levels, then the MACD signal would turn negative instead of positive. This makes sense since the MACD line measures past performance rather than future potential.

The MACD line only works properly when the underlying asset follows a normal distribution. In other words, there must be enough data points available so that the average value of all those values will fall within a reasonable range.

Frequently Asked Questions

What Is A Moving Average?

The most basic definition of a moving average is simply "a mean." It's just like taking the average of a bunch of numbers together. But unlike the arithmetic mean, the geometric mean takes into account the size of each individual number.

For example, let's say we have three numbers - 1, 2, 3. Their sum equals 6. So their average is 2. Now let's add another set of numbers - 4, 5, 7. Their total is 12. Therefore, their average is 4. Notice that this calculation gives us exactly the same result as before! That's why they call them moving averages because they take into consideration the size of each individual value.

How Do I Calculate My Own Moving Average?

To calculate your own moving average, first, find out how many days' worth of prices you want to include in your calculations. Let's assume our sample consists of daily closing prices from January 1st until today. We'll need to figure out which day represents one full week. To do this:

1.      Divide the length of the sample by seven.

2.      Multiply that number by 365.

3.      Round up to the nearest whole number.

Bottom Line

A moving average is a straightforward way to smooth out noisy signals over long-term charts. You can also use it to identify short-term trend reversals. If you'd like more help understanding moving averages, check out my free video course here.