Day Trading Encyclopedia

Technical Indicators MACD

Moving Average Converse Divergence (MACD)

The Moving Average Convergence Divergence (MACD) is a momentum and trend indicator that turns two moving averages into oscillators. It is composed of two exponential moving averages (EMA) and a histogram. There are three components to that are calculated.

MACD Line = (12-period EMA – 26-period EMA)

Signal line = 9-period EMA

Histogram = MACD Line – Signal Line

The MACD line and Signal line are used as oscillators similar to stochastic and RSI crossovers. The MACD line is the lead oscillator and Signal line is the laggard oscillator. The chart has a zero line mid-point scale with incremental positive and negative numbers above and below. A range bound market usually keeps the oscillations between 1 and –1 near the zero line. Be aware some charting platforms may place a decimal point ahead of the whole number (I.E. 0.2 rather than 2).

The histogram represents the differential between the MACD line and the Signal Line. As the MACD accelerates faster away from the laggard Signal line, the histogram bars increase relative to the direction of the MACD line. A quickly rising MACD line will increase the histogram bars above the zero line. A sharp falling MACD line will increase the histogram bars under the zero line. This is a loose momentum indicator. As the momentum slows down and the Signal line catches up to the MACD line and the differential between the two lines tighten, the histogram will also start to deflate which indicates the waning momentum and possibility of a reversal.

Using the MACD

The MACD line crossover up through the Signal line can be used as a buy trigger through the zero line. The position can be held until the MACD crosses back down through the Signal line and or when the histogram bars start to contract, which indicates the lead MACD is losing momentum as the differential tightens with the Signal line.

A sell/sell short trigger can form when the MACD line crosses down through the Signal line as the histogram bars contract above the zero band and expand under the zero band. Keep in mind that an oscillating range-bound market usually caps the range between the 1 and the –1 band. Therefore, MACD crossovers that form above the 1 band form stronger sell/short signals for a reversion back towards the zero line. This also applies to buy triggers that form beyond –1 as the lower the negative band is when a crossover buy trigger crossovers that form well below the –1 band forms stronger slingshot style reversions back towards the zero line.

Divergence signals can be derived similar to RSI divergence by connecting the higher highs on the stock simultaneously with the higher highs on the MACD oscillator during uptrends. During downtrends, the trendlines connect the lower lows on the stock price and MACD oscillator. Divergence triggers can give an early signal to prepared traders so they can anticipate and react quickly on the crossover triggers.