Moving Average Convergence Divergence

Moving Average Convergence Divergence is a technical analysis tool traders use to determine the stock market's future trend. The concept of an exponential moving average (EMA) is employed in the moving average convergence divergence calculations. EMA is utilized when MACD is composed of two lines.

MACD is an indicator of price momentum, showing the direction of the stock price is in the market. However, it detects trend reversals only after they happen and hence needs to be used with caution. Investors can analyze the profitability shown by MACD to make decisions regarding the price of a particular stock.

• The moving average convergence divergence (in short, MACD) is a technical indicator that helps traders pace their entry and exit into the stock market.
• It helps to analyze the market momentum and trends to minimize losses.
• The MACD indicator measures the convergence and divergence of two moving averages. The mid-term moving average is subtracted from the short-term moving averages to arrive at this value.
• MACD crossing the zero or central line is generally interpreted as a buy or sell signal. Typically the central line cutting from the bottom is considered a buy signal.

The Moving average convergence divergence concept is a technical analysis indicator for analyzing the stock market. Gerald H. Appel, an active trader and author developed the idea in 1979. It acts as an indicator of the price momentum prevailing in the market. Through this, investors can predict the direction in which stock prices are moving in the stock market. The MACD technique tracks the convergence and divergence between two moving averages. The calculation involves deducting the mid-term moving average from the short-term moving averages. Usually, one takes three values here. The most commonly used ones are the 12-day and 26-day moving averages. The general rule during the choosing of values is that, one should be of a shorter period, and the other should be of a longer period. Exponential moving averages (EMA) helps to calculate these. Calculation done through software such as moving average convergence divergence python can be of immense help.

MACD histogram depicts these values and show the trend. Large bars of moving average convergence divergence strategy indicate divergence in a moving average convergence divergence histogram, whereas small bars indicate a convergence of the moving averages. The MACD trend is bullish when the short-term moving averages are above medium-term moving averages and bearish in reverse situations.

A positive MACD indicates that the short-term moving averages are above the medium-term ones and, therefore, bullish. Negative MACD thus shows bearish trends. Generally speaking, MACD crossing the zero line or the central line is a buy or sell indication. The zero line from the bottom is a Buy Signal, and the central line cutting from the top is a sell signal. However, the zero-line crossover rules have a disadvantage; the events occur with a lag. This is because MACD is a trend-following indicator.

There will be lags in moving average convergence divergence strategy even if investors or traders increase the sensitivity by selecting shorter moving averages. To avoid this, traders lean towards more complex trading rules such as signal crossover and divergence. However, MACD divergence cannot be the sole indicator of a reversal of prices. This is because MACD trend lines will diverge as soon as the price begins to level out because price momentum cannot last indefinitely.

MACD calculation can be done by using the following formula:

MACD = EMA 1 (12-day closing prices) – EMA 2 (26-day closing prices)

EMA (t) = α * (Closing Price) t + (1-α) * EMA (t-1) Where α = 2/ (N+1)

From the above moving average convergence divergence formula we can interpret that the concept is calculated by deducting the long-term exponential moving average (EMA), which is 26 periods from the short-term EMA, which is 12 periods.

The exponential moving average can be referred to as that type of moving average which puts more emphasis on the current or most recent data points. It is very useful tool to evaluate the security trends, whether its bullish or bearish over a certain duration of time and is widely used in technical analysis charts. It gives equal weight to all the data points or observations.

Thus, in the process the analysis or investor needs to calculate using the following steps:

• For the selected time period, calculate the EMA for 12 period.
• Same, as above, the EMA has to be calculated for the selected time period, but only for 26 periods.  
• From 12 period EMA, deduct the 26 period EMA values to get the MACD line.
• Then histogram is created by subtracting the signal line from the MACD line.

Thus, on top of the histogram line, the nine-period EMA points are overlaid.

The MACD generates the following kind of signals:

The Signal Line Crossovers:

The signal line is the EMA of the MACD. The market is considered bullish when the MACD crosses above the signal line. On the other hand, the MACD line goes down and crosses below the signal line; this is known as a "bearish crossover."

Centre Line Crossovers:

The trend is bullish when MACD crosses the zero line and goes above. At this point, a buy signal occurs. Conversely, When MACD drops below zero line and becomes negative, it is a bearish centre line crossover. At this trend, a sell signal is generated. 

Divergence:

This happens when the MACD when does not follow the price action deviates. For example, it is a bullish divergence when the price touches a new low, but the MACD does not follow it to confirm by making a new low. Similarly, it is bullish when the price touches a new high, but the MACD does not follow it and makes a new high.

However, MACD indicators do not work in a range-bound market and are thus ineffective. In addition, there can be misinterpretations made in short durations. For example, there can be a negative crossover, but the occurrence of a steep price rise can be seen. Hence, the events have to be looked at for a longer duration to predict real outcomes.

Let us observe the following India Tourism Development Corporation chart to understand the concept better.

Source

One can find the MACD indicator below the price chart of the company. It is represented by the red and blue lines that oscillate without any particular boundary. The blue line is the MACD line, while the red line is the signal line. Moreover, the MACD histogram denotes the differences between the MACD and signal lines.

As noted above, the two lines’ crossover provides bearish or bullish signals. In the chart, we can find that when the MACD line crossed over the signal line from below on August 24, 2021, a bullish trend materialized. On the other hand, when the MACD line crossed the signal line from above on June 21, 2021, a bearish trend materialized.

If one wishes to learn more about the MACQ indicator and develop a comprehensive understanding, one can consider looking at the multiple charts already published on the TradingView platform. Various charts include the MACD indicator, giving an idea regarding how one can utilize the toll to make significant profits.

The below example of applying the moving average convergence divergence formula gives readers the basic idea of how the concept works.

Suppose Dan wants to invest in the stock market and analyze recorded data points regarding MACD. Analyzing the data over time, he understands stocks of umbrella corporations that sell umbrellas behave in a certain way over particular seasons. When the autumn season, the umbrellas are not in demand, is about to begin, the MACD tends to turn up and cross above the signal line. This indicates buying time. Dan has to buy the stocks to get them at low prices. When the rainy season came, He observed the MACD going below the signal line. This indicated a sell signal that he could avoid losses and profit by making better choices. For convenience, individuals can attain software's help investors can use Moving average convergence divergence python for easy calculations.

Thus, from the above example, we learn about how the moving average convergence divergence formula indicator works and how we can take its help to decide on a trading strategy for a stock. This not only gives us confidence regarding our investment decision but also acts as a guide to help us relate the charts with what is happening in the market.

Let us learn about the uses of this indicator in details.

• It is an indicator that can be used equally at all times of the trading season and for stocks related to any sector.
• Since it is important for every trader to be able to measure the momentum behind any trend, which is often disturbed by price volatility, this indicator can help in identifying those trends very easily.
• It generates signals to trade and take action on any stock by measuring the momentum behind those trends.
• From the above points it can be derived that this particular method also acts as a guide to decide on the entry and exit points, be it a stock or any other asset that can be traded.
• It is also possible for the trader to calculate or anticipate the strength or the reliability of buy and sell decisions taken based on the signals. This can be done by looking at the crossover distances.
• The indicator can be used based on different timeframes. The chart can be adjusted based on hourly, daily, monthly time frame, etc and the signals can be verified.
• It can be used both for long term trades and short-term trades.
• It is a versatile tool that can provide signals that is not only easy to understand and interpret but also visually appealing to the users.

This has been a guide to what is Moving Average Convergence Divergence(MACD). We explain the formula & how to read it, with example & uses. You can learn more about it from the following articles –

• Technical Indicator
• Oversold
• On-Balance Volume