What is the MACD indicator?
The word MACD is an abbreviation for Moving Average Convergence Divergence, which means moving average convergence and divergence in Arabic. It is an oscillator-type indicator widely used by traders for technical analysis (TA).
The MACD is a trend-following tool that uses moving averages to determine the momentum of a stock, cryptocurrency, or other tradable asset.
The Moving Average Convergence Divergence (MACD) indicator was developed by Gerald Appel in the late 1970s and tracks pricing events that have already occurred and therefore falls into the category of lagging indicators (which provide signals based on previous price action or past data). The MACD indicator can be useful for measuring market momentum and potential price trends and is used by many traders to identify potential entry and exit points.
Before getting into the mechanics of MACD, it is important to understand the concept of moving averages. A moving average (MA) is simply a line that represents the average value of past data over a pre-defined period. In the context of financial markets, moving averages are among the most popular indicators for technical analysis (TA) and can be divided into two different types: simple moving averages (SMAs) and exponential moving averages (EMAs). While simple moving averages weight all data inputs equally, exponential moving averages place more importance on more recent data values (more recent price points).
How the MACD indicator works
The MACD indicator is created by subtracting two exponential moving averages (EMAs) to create the main line (MACD line) which is then used to calculate another exponential moving average (EMA) that represents the signal line. In addition, there is a MACD histogram calculated based on the differences between these two lines. The chart and the other two lines fluctuate above and below the center line, which is also known as the zero line.
Therefore, the MACD indicator consists of three components moving around the zero line:
MACD Line (1): Helps identify upward or downward momentum (market trend). It is calculated by subtracting two Exponential Moving Averages (EMA).
Signal Line (2): It is an Exponential Moving Average (EMA) line of a MACD line (usually 9 periods). Combined analysis of the signal line with the MACD line may be useful in identifying potential reversals or entry and exit points.
Chart (3): It is a graph that represents the deviation and convergence of the MACD line and the signal line. In other words, the histogram is calculated based on the differences between the two lines.
MACD line
Exponential Moving Averages are generally measured according to the closing prices of an asset and the periods used to calculate EMAs are usually set to 12 periods (faster) and 26 periods (slower). Period may be calculated in different ways (minutes, hours, days, weeks, months) but this article will focus on everyday settings. However the MACD indicator may be customized to accommodate different trading strategies.
Assuming standard time ranges, the MACD line itself is calculated by subtracting the 26-day EMA from the 12-day EMA.
As mentioned earlier, the MACD line oscillates above and below the zero line and this signals center line crossovers to tell traders when the 12-day and 26-day EMA change their relative position.
Signal line
The signal line from the 9-day EMA is calculated from the main line by default, and as such provides further insights into its past movements. Although not always accurate, when the MACD line and the signal line intersect these events are usually considered trend reversal signals especially when they occur at the extremities of the MACD chart (well above or well below the zero line).
MACD chart
The chart is nothing more than a visual record of the relative movements of the MACD line and the signal line. It is calculated simply by subtracting one from the other.
However, instead of adding a third moving line, the graph consists of a bar graph which makes it easier to read and interpret visually. Note that the chart bars have nothing to do with the asset's trading volume.
MACD settings
As we discussed before, the default settings of the MACD are based on 12, 26 and 9 period EMAs hence the MACD is called (12,26,9). However, some technical and charting analysts change periods as a way to create a more sensitive indicator. For example MACD (5,35,5) is often used in traditional financial markets alongside longer time frames such as weekly or monthly charts.
It should be noted that due to the high volatility of cryptocurrency markets, increasing the sensitivity of the MACD indicator can be risky as it will likely lead to more false signals and misleading information.
How to read MACD charts
As the name suggests, the Moving Average Convergence-Divergence (MACD) indicator tracks the relationships between the moving averages. The relationship between the two lines can be described as either convergence or divergence. They converge when the lines are drawn toward each other and diverge when they move apart.
However, the relevant signals for the MACD indicator are associated with so-called crossovers, which occur when the MACD line crosses above or below the center line (central crossovers at the center line) and above or below the signal line (crosses across the signal line).
Keep in mind that intersections in the middle line and signal line may occur multiple times resulting in many false and deceptive signals especially regarding volatile assets like cryptocurrencies. Therefore, you should not rely on the MACD indicator alone.
Intersections in the axis
Mean crossovers occur when the MACD line moves into either positive or negative territory. When it crosses above the center line, a positive MACD value indicates that the 12-day EMA is larger than the 26-day. In contrast, a negative MACD appears when the MACD line crosses the center line which means the 26-day average is higher than the 12-day. In other words, a positive MACD line indicates a stronger upward momentum while a negative line may indicate a stronger downward trend.
The intersection in the signal line
When the MACD line crosses above the signal line, traders often interpret it as a potential buying opportunity (entry point). On the other hand, when the MACD line crosses below the signal line, traders tend to view it as a selling opportunity (exit point).
While signal crosses can be useful they are not always reliable. For example if the crossover signal suggests buy but the MACD line indicator is below the middle line (negative) then market conditions may still be considered bearish. Conversely if the signal line crossing indicates a potential sell point but the MACD line indicator is positive (above the zero line) then market conditions are likely to be bullish. In such a scenario following a sell signal may increase risk (given the larger trend).
MACD and price divergences
MACD charts may also provide insights through the differences between the MACD chart and the asset's price action.
For example if the price action of a cryptocurrency is recording a high while the MACD is creating a lower high we will have a bearish divergence which indicates that despite the price increase the uptrend momentum (buying pressure) is not as strong as it was. Bearish divergences are usually interpreted as selling opportunities because they precede price reversals.
Conversely, if the MACD line forms two bullish bottoms in line with two bearish bottoms on the asset price then this is considered a bullish divergence which indicates that even though prices are falling the buying pressure is stronger. Bullish divergences precede price reversals which may indicate a short-term bottom (from a downtrend to an uptrend).
Concluding thoughts
When it comes to technical analysis, the Moving Average Convergence Divergence indicator is one of the most useful tools available. Not only is it relatively easy to use. Rather, it is because it is very effective in identifying market trends and market momentum.
Like most technical analysis indicators, the MACD is not always accurate and may provide many false and misleading signals especially in relation to volatile assets or during weak or sideways price movement. Therefore, many traders use the MACD indicator in combination with other indicators such as the Relative Strength Index (RSI) to reduce risks and confirm signals.