What is Moving Average Convergence Divergence (MACD)? This is the question that I have chosen to answer this week.
I normally receive several questions from my readers through email, and I end up writing blog posts around some of these questions if I think everyone else visiting the blog would benefit.
The Moving Average Convergence/Divergence Oscillator (MACD), which was developed by Gerald Appel in the late seventies, is among the simplest and most effective momentum indicators there is.
The MACD tends to change two trend-following indicators; moving averages, into a momentum oscillator by removing the longer moving average from the shorter moving average.
This leads to the Moving Average Convergence/Divergence oscillator (MACD), giving the best of both trend following and momentum.
The MACD changes above and below the zero line as the moving averages join, cross and diverge. Traders can search for signal line crossovers, centerline crossovers, and divergences to create signals.
Since the MACD indicator is limitless, it is not specifically useful for finding overbought and oversold levels.
The moving average convergence divergence is a technical analysis indicator that aims at identifying changes in a share or currency pair price momentum.
As a result, it gathers data from various moving averages to assist traders in identifying possible opportunities near resistance and support levels.
Convergence means that two moving averages are coming together, while divergence means that they are moving away from each other.
There are 4 components that make up the MACD indicator:
- The signal line that identifies changes in price momentum and serves like a trigger for buy and sell signals.
- The MACD line, which measures the distance between two moving averages.
- The histogram, which represents the difference between the MACD and the signal line.
- The zero line, on the other hand, shows the difference between a positive price trend and a negative price trend.
Now that you know what is moving average convergence divergence, I can proceed and outline the four components into detail.
How is the Moving Average Convergence Divergence Built?
This is commonly calculated as per the difference between 26-period slow moving averages and 12-period fast-paced exponential moving averages.
A simple moving average is determined by putting together the closing prices for successive periods and later dividing the total by the number of periods involved.
An exponential moving average is an analogous (similar) to a simple moving average, except that it uses exponential weighting to give more weight to more recent closing price data.
Thus, the most recent data gets the heaviest weight, and the weight from every data point lowers exponentially moving back chronologically.
This is also referred to as the “trigger line,” which is calculated using a 9-day (period) exponential moving average of the MACD line itself.
The signal line is taken to be a slower-moving picture of price action and is used as a foundation of comparison for the MACD line.
It is a parallel line across the chart that shows the difference between a positive price trend and a negative price trend.
The zero line also signifies the point at which the MACD and the signal line meet.
It is a symbol of the greatness of the difference between the MACD line and the signal line.
It will show as a flat, curved bar graph may be above or below the zero line.
The basis for using the MACD is that by observing moving averages, it could disclose the momentum or strength of a prevailing trend.
When prices are rising, the fast-moving 12-period moving average increases at a faster pace compared to the slower moving 26-period moving average. As a result, the MACD line is most likely to move upwards.
In case they are decreasing, the MACD line will slope downwards.
Having learned what is moving average convergence divergence, it is also good to be conversant with the MACD formula.
The Formula for MACD
MACD line =[12-Period EMA − 26-Period EMA ]
Signal line = [9-day EMA of MACD]
Histogram = [MACD – Signal Line]
You calculate the MACD by subtracting the long-term EMA (26 periods) from the short-term EMA (12 periods).
An exponential moving average (EMA) is a kind of a moving average (MA) that consigns an immense weight and importance on a majority of the recent data points.
The exponential moving average is also known as the exponentially weighted moving average.
An exponentially weighted moving average responds more importantly to recent price variations than a simple moving average (SMA), which adds similar weight to all observations in the period.
Trading Using the Moving Average Convergence/Divergence Oscillator
Since there are two moving averages with varying “speeds,” the faster one will definitely be quicker to respond to price movement than the slower one.
If a new trend takes place, the fast line will react first and then cross the slower line.
Once this crossover has happened, and the fast line begins to move away or diverge from the slower line, it normally signifies that a new trend has formed.
In reference to the chart above, it is clear that the fast line crossed under the slow line and properly identified a new downtrend.
Take note of that once the lines cross, the histogram momentarily disappears. The aspect is attributed to the fact that the variance between these two lines is 0 (zero) during this period.
With the commencement of the downward trend as the fast line is deviating away from the slow line, the histogram becomes bigger, which is a good sign of a strong trend in the horizon.
From the EURUSD’s chart below, the fast line crossed high past the slow line as the histogram disappeared.
This was an indication that the brief downtrend would ultimately reverse.
As a result, EURUSD started moving up as it initiated a new uptrend.
The information above has provided an insight as to what is moving average convergence divergence and how to use it as a forex trader.
However, just like any other trading tool out there, it is good that I mention the limitations that come with using the MACD indicator.
Read: 200 Day Moving Average
Limitations of the Moving Average Convergence Divergence Indicator
Among the major problems with divergence is that it can regularly signal a possible reversal, but then no reversal actually occurs. This means that it has given a false positive.
Another limitation is that divergence doesn’t predict all reversals. It has the tendency of forecasting numerous reversals that don’t happen, and it is also inefficient in identifying some real price reversals.
“False positive” divergence will mainly happen when the price of an asset moves sideways, like in the triangle pattern following a trend or a range.
A sideways movement, slowdown in the momentum, or slow trending price movement will likely lead to the MACD pulling away from its previous extremes and sink toward the zero lines even in the absence of a true reversal.
In my opinion, the major limitation of using the MACD indicator is the same as the one with all indicators; it usually lags behind.
As a matter of fact, it is simply an average of historical prices.
The fact that this indicator signifies moving averages of other moving averages and is smoothed out by another moving average, this increases the lagging threshold.
Despite this, MACD is among the most preferred indicators by traders in the forex market.
It is my belief you are now informed with regards to what is moving average convergence divergence. In case you have any question, you can reach me via email.