What is MACD?
The Moving Average Convergence Divergence, also known as MACD is a trend-following technical indicator and a momentum oscillator, that is primarily used to find a security’s trend.
MACD can be calculated by subtracting the 26 periods EMA (Exponential Moving Average) from the 12 periods EMA. The resultant formula forms the MACD line. Then a 9 period EMA, also known as “signal line” is plotted over the MACD line, that functions as a trigger to buy or sell a security.
Trade can buy a stock when the MACD line crosses above the signal line and short when the MACD line crosses below the signal line.
Table of Contents
Calculation of MACD
The formula to Calculate MACD is:
MACD = 12-Period EMA − 26-Period EMA
Moving Average Convergence Divergence (MACD) can be calculated by subtracting the longer-term 26 period EMA from the shorter-term 12-period Exponential moving average.
The MACD indicator is commonly used with the value of 12, 26, and 9, and some trader may change the figures, depending upon their trading style.
MACD Histogram speaks for the difference between the MACD and its 9-day Exponential moving average also known as the signal line. The histogram is turned positive when the MACD line crosses above the signal line and turns negative when the MACD line crosses below the signal line.
As you can see in the above chart MACD is generally displayed with a histogram, which is a volume diagram in this chart. The red bar represents the selling volume and the green bar represents the buying volume.
The MACD indicator is all about the convergence means ‘the state of converging’ and divergence means ‘the state of diverging’ of the two exponential moving averages. Convergence occurs in MACD when the moving averages are moving towards each other. Divergence occurs when the moving averages are moving away from each other.
The 12-period exponential moving average is faster and responsible for most of the MACD movements. The 26-period exponential moving average is slower and very less responsive to the price action of the underlying security.
MACD Vs RSI
The main aim of relative strength index (RSI) is to find, if a stock or other security is overbought or oversold and according to that finding traders mostly pace buy or sell orders.
Whereas the moving average convergence divergence (MACD) brings two exponential moving average together and it measures the relationship between them. The Relative Strength Index (RSI) compares the price action and recent highs and lows.
Most often technical analysts use both the indicator together to find a better trade and it helps them to trade confidently. For example, A stock is breaking its highs and the RSI value shows above 70, which means the stock is overvalued, but the MACD is still increasing in buying momentum. In that case, a trader should wait for the conformation in both the indicators
Limitations of Moving Average Convergence Divergence
- The main limitation of MACD is that it is not particularly good for identifying the overbought and oversold level of stock. Though, it is possible to find levels that are previously overbought or oversold.
- The MACD also does not have any upper limits or lower limits to bind the security’s movement. During a sharp upside or downside moves, it can continue to any extent, even beyond its historical move.
- Trade may see several false breakouts (false alarm) if security moves side-wise.
The MACD indicator is a very good technical indicator because it brings together the momentum of security and trend of the security in a single indicator. This indicator is effective in daily, weekly, or monthly or yearly charts and that depends upon the traders.