Whatever it is that you’re trading, it’s often all too easy to feel like you’re drowning in data. With lots of information at our disposal, there’s a very real risk of not seeing the wood for the trees; of failing to identify chances to buy on the upswing and sell on the downswing. That’s why visual indicators can be so compelling. They distil data into a format that’s easy to take on board and provide us with a handy cue on when and how to act.
A MACD chart is a prime example of this. Understanding how to read a Moving Average Convergence/Divergence (MACD) chart can give you a vital heads-up on how a stock or index is likely to behave. Here, we look closer at what the graphs actually mean…
MACD was developed over four decades ago. Put simply, these indicator tools are still used widely today because they can give a useful snapshot visual representation of both momentum and trend. Whereas trend is concerned almost exclusively with clearly quantifiable historical price data, momentum is concerned more with the bigger picture to try and determine the rate of change.
To take into account momentum in market analysis, it’s usually necessary to take into consideration multiple forms of data from a wide range of sources, such as earnings reports for companies, what’s happening in the relationship between buyers and sellers in the market in question, plus historical behaviour in terms of price rises and falls.
The big problem with momentum data is the inability to automatically put a figure on it. This is where oscillators come in: put together by financial mathematicians, they employ various formulas to measure price changes. Their main purpose is generally to tell traders about a possible start of a new trend, or its reversal. Taking the form of lines drawn under the price chart for the stock, index or currency in question, their name comes from the fact that their values invariably oscillate in a certain range. They provide the ability to assess the immediate market position with reference to the indicator’s position inside this range.
The MACD oscillator, with its inbuilt ability to plot the difference between moving price averages for several time periods, is especially useful at identifying divergences between the indicator and the short-term market price trend. So let’s say the market price reaches an all-new high: what’s going to happen next? A quick glance at the MACD reveals that it has stopped rising at a level that is lower than the previous line. The implication is that the upward trend is running out of momentum and that we could be about to see a downward trend.
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Take a look at this snapshot of IBM stock (under chart display, select MACD next to Lower Studies). Typically, a MACD histogram takes the difference of a 12-day exponential moving average (EMA) of prices and a 26-day EMA and the result is displayed in a single line – the MACD line (Here, it’s plotted in red). MACD indicators generally have a further line (referred to as the “signal line”) which is the EMA of the main line ( blue). The moving average is set to 9 by default.
The MACD line oscillates above and below the zero line (also known as the centreline). Positive MACD means that the 12-day EMA is above the 26-day EMA.
Signal Line Crossovers
In the IBM chart, notice how the blue signal line, for the most part trails the red MACD main line. Generally, a buy signal bullish crossover happens when the MACD turns upwards and crosses the signal line. A bearish crossover occurs when the MACD turns down and crosses below the signal line.
When the MACD moves above the zero line to turn positive, this is a bullish indicator. If the 12-day EMA moves below the 26-day EMA, the MACD turns negative by moving below the zero line – i.e. a bearish crossover.
A divergence happens when the MACD lines follow a different course to price behaviour. A possible bullish indicator here is where the MACD starts to advance and yet the security is losing value – or where the stock price records a lower low and the MACD forms a higher low. Both of these are examples of positive divergence. On the other side, a bearish sign in the form of negative divergence occurs where the stock advances or moves sideways and the MACD maps a lower high or a decline. This could be a warning of a peak on the cards.
The MACD chart has a reputation of being one of the most reliable indicators around – but as with all indicators, is far from infallible. Getting the most out of it requires knowledge of how best to apply it to a particular security or index and it’s worth noting that the standard 12 and 26-period EMA can be tailored for each different subject matter. Look out for multiple signals and combine with other tools to integrate it into your strategy.