- What is MACD indicator?
- How to use MACD indicator to find ideal entry/exit points.
- Understanding convergence and divergence in MACD.
Moving Average Convergence and Divergence (MACD) is a key indicator used by many traders in their technical analysis. MACD indicator shows the direction, strength and momentum of the price changes which helps in predicting an ideal entry/exit point for a trade. Although MACD is based on moving average it is able to provide much better signaling by combining multiple averages.
The trend following moving average is converted into momentum oscillator by subtracting the longer duration moving average from the shorter duration moving average. Developed by Gerald Appel back in 70’s it is colloquially called as “Mac-Dee” or MACD (Does not hold any relation with the Mac burgers).
What is MACD:
Fig 1: IBM MACD indicator is used to find an ideal trading point within IBM’s stock price.
A very common usage of MACD is MACD (12, 26, 9) which signifies the duration for various lines.
MACD is formed by subtracting EMA(26) from EMA(12). In the above graph EMA (26) is the smoother line on the upper part of the graph in brown whereas EMA(12) follows the price changes more closely and is the purple line on the upper part.
MACD Line: The prominent green line is the MACD line which is formed after this subtraction. It oscillates around the zero (black) line shown in the lower half of the graph.
Signal Line: Besides the MACD line there is another signal line which is EMA line of the MACD line itself. The duration of this line is 9 days. Hence it takes the past 9 values of the MACD line and finds the EMA for a given day. This is the yellow line shown in the bottom half of the graph. Both the MACD and signal line oscillate around the zero line.
Histogram: The histogram in the lower half of the graph is derived after subtracting the signal line value from the MACD line value. Hence if MACD is above the signal line the histogram will have positive values and negative if MACD line is below the signal line.
MACD Buy Signals
There are three different points of trading which can be seen in the graph:
1-2) These two points signify crossing over of EMA(12) and EMA(26) lines on the upper part of the chart. At the same time when both the lines are crossing over the difference between them is zero. This is shown by the MACD line which touches the zero line at the lower half of the graph. (Point 2)
3-4) Another indication of a bullish trend is when MACD line cuts its own signal line. MACD crossover point signifies a change in the trend. By going above the signal line, MACD line shows a bullish momentum in the stock.
5-6) Finally another indication of a bullish trend developing is by looking at the histogram at point 6. The histogram has hit a lower point and is now moving upwards as shown by a line at point 6. This upward move is an indication that the price will change to an upward trend. This will be an ideal “buy” indication.
While trading all the three points are signals for a bullish trend. However traders are always looking at gauging a price trend at the earliest to get the maximum benefit. We can clearly see that the EMA crossover at point 1 is a couple of days later than MACD- Signal line crossover at point 3,4 and this is a couple of days later than the histogram indication at point 5,6. Consequently, the overall price benefits are very different at point 1, 3 and 5 as can be seen from the upper side of the graph.
If a trader is able to get a correct indication at point 5 instead of point 1 there would be much higher profitable trades.
Similarly during a bearish trend the same chronology will be followed. First the histogram will start going into the negative territory, next the MACD- Signal line crossover will take place and finally MACD line will touch the zero line. MACD helps by being an early indicator and gives an early Buy/Sell signal.
Drawbacks Of Using MACD Indicator
However MACD has its drawbacks also along with the advantages shown above. One of the biggest drawbacks while using MACD is the whipsaws in the chart.
Whipsaws are wrong indications provided by MACD. These generally occur when the momentum of the price movement decreases. Although the overall momentum of the price movement was bullish the trend showed a slight decrease at point 7. This decrease is quickly interpreted by MACD indicator as a change in the trend. This will cause the MACD and signal line to cross one another several times as can be seen from point 8 and 9. On the other hand the EMA lines in the upper part of the chart do not cross over and thus do not show a change in the direction of the price movement. These whipsaws can cause erroneous decisions where a small decrease in momentum is shown as a change in trend which will lead to wrong selling/buying decisions.
Traders protect themselves from these whipsaw movements by using multiple tools which will also give an indication of actual momentum change.
Another major indicator within the MACD chart is when the price movement points to one direction whereas the MACD line points in the other direction. This is called as divergence within MACD.
We can see this from the following figure:
Fig 3: IBM’s stock shows lower lows made by the stock at point 1, 2 and 3. At the same time the MACD line is making higher lows in 6, 5 and 4. This gives an early indication that the bearish trend is ending and that a change in trend is in offing.
As we saw earlier it is always better to have an earlier indication about the movement of the price. When we look at the above figure we see that the prices keep on falling and reach lower lows through 3, 2 and 1. However at the same time the MACD does not follow the same pattern. Point 6 is lower than point 5 which is lower than point 4. This shows that the bearish trend is soon coming to an end and there should be a good buying opportunity.
By noticing the pairs of 3-6 and 2-5 a trader should be able to predict a change in the trend and point 1-4 should give an ideal buying signal.
Contrary to divergence when both the price movement and MACD line point towards the same bullish or bearish trend it is called as convergence within MACD. MACD convergence and MACD divergence should be closely watched as they are the earliest signs of a possible change in trend and hence provide good entry/exit signals. However all trading must be done with prudence and after having a solid foundation about the various tools and understanding risk equity.
These trading signals along with other tools can help a trader get higher returns and protect against any losses. Many statistical researches have shown how traders are able to earn positive real returns after subtracting the transaction costs by using these tools. A complete mastery over MACD indicator is a must for any serious trader and using it in combination with other tools is a sure shot way to becoming a pro trader.