What is the moving average convergence divergence (MACD) indicator and how do you use it?
Traders use a wide range of technical indicators to generate trading signals when making their moves in financial markets. These indicators help traders analyze price action to determine price trends, the momentum of those trends, the best time to buy, and the best time to sell financial assets.
The moving average convergence divergence indicator (MACD indicator) is one of the most popular tools in a trader’s toolbox.
The tool is a momentum indicator built under the idea that momentum changes happen ahead of price changes. The idea is that traders can track and analyze the momentum of price movements to determine where the value of the asset is likely headed in the future.
What Is the Moving Average Convergence Divergence (MACD) Indicator?
The MACD is a momentum oscillator that shows the relationship between two moving averages of a financial asset’s price. Those moving averages include the 26-day exponential moving average (EMA) and the 12-day EMA. Traders also use a signal line with this indicator which is plotted using a 9-day EMA of the MACD. Gerald Appel, founder of the Systems and Forecasts newsletter, developed the indicator in the late 1970s.
It’s important that you understand moving averages before going further, because they are the building blocks that form the MACD and the signals it generates.
Moving averages reveal average prices over time. At the close of every trading session, the new closing price is added into the calculation and the oldest is removed, helping smooth the volatility of price movement in the trading chart.
The MACD uses exponential moving averages (EMAs). EMAs are time-weighted averages, meaning the newest data is given more importance than older data. This makes them more sensitive to the most recent price movements.
What the MACD Measures
The MACD is a momentum oscillator, meaning it measures the veracity of price movements in the market.
The concept behind the indicator is that price changes happen as a result of investor movements. When investor demand for an asset climbs, the price of that asset follows, and when demand declines, the price falls.
Because all investors don’t make their moves at the same time, tracking the speed of price movements, or speeding and slowing of demand, indicates when reversals are likely to occur. Traders see these coming reversals as buy and sell signals.
How to Calculate MACD
To calculate the MACD, subtract the long-term, 26-period EMA from the short-term, 12-period EMA:
MACD = 12-Day EMA – 26-Day EMA
Most charting platforms do this calculation for you and plot the results alongside an asset’s price chart.
Let’s say ABC stock has a 12-Day EMA of $25.12 and a 26-Day EMA of $24.93. The moving average convergence divergence formula using the data in the example would look like this:
MACD = $25.12 – $24.93 = $0.19
The value of the MACD is plotted on the graph over time. Investors watch as the value increases and decreases, creating buy and sell signals.
Signals are also created by comparing the movement of a signal line in relation to the MACD line. The signal line is calculated by taking a nine-day EMA of the MACD.
How to Read the MACD
There are three important lines to watch when reading MACD data:
- MACD Line. The MACD line is plotted on the chart based on MACD values over time. When the MACD line crosses above zero, the trend is considered bullish, and the trend is bearish when the MACD line crosses below zero.
- Signal Line. The signal line — the line created by taking a nine-day EMA of the MACD — is also plotted on the chart. Traders pay close attention to the relationship between the MACD line and the signal line, specifically looking for points at which the two lines cross for trading signals.
- MACD Histogram. The MACD histogram is a visualization tool that helps traders measure the difference between the MACD line and the signal line. Investors read these two lines converging or diverging as buy and sell signals.
Ways to Interpret the MACD
The MACD generates trading signals in multiple ways. Some of the most common ways to interpret the indicator include:
MACD crossovers happen when the MACD line crosses over the signal line on a trading chart, generating signals to buy and sell the asset being analyzed. Here’s how they work:
- Bullish Crossover. A bullish crossover happens when the MACD line crosses over the signal line. When this happens, it acts as a signal that the stock is headed for an uptrend.
- Bearish Crossover. A bearish crossover happens when the MACD line crosses below the signal line. When this occurs, it’s a signal that the stock price is headed for a downtrend.
Crossovers can also happen without a signal line:
- Bullish Crossover. When the MACD line crosses over zero, the move is considered to be bullish, signaling upward movement ahead.
- Bearish Crossover. When the MACD line crosses below zero, the move is considered bearish, signaling downward movement ahead.
See the chart below for an example. The chart shows Apple’s daily stock price and the MACD over a six-month period ending April 7, 2022.
At the bottom of the image, you’ll notice a sub-chart with a red line, a black line, and a blue histogram. This section charts the MACD. The black line is the MACD line, and the red line is the signal line.
Around November 15, 2021, a bullish crossover took place, preceding a sharp rise in Apple’s stock price. In mid-December, a bearish crossover took place, followed by significant downward movement.
There are two more bullish crossovers and one more bearish crossover on the chart that occured in 2022. Take a moment to see if you can spot them.
If you spotted the bullish crossovers in late January 2022 and mid-March 2022, and the bearish crossover in mid-February 2022, you’re on the right track.
The MACD histogram is a series of bars plotted in the center of the MACD chart. The bars seem to grow above and fall below the zero line, creating easy-to-spot bullish and bearish signals.
- Bullish Histogram Signals. When the MACD line crosses above zero, a bar in the histogram will start a series of bars that climb above the zero line. This event indicates that momentum is moving in the upward direction and an uptrend is on the horizon.
- Bearish Histogram Signals. When the oscillator’s line crosses below zero, a bar in the histogram will start a series of bars that fall below the zero line. This event indicates that momentum is moving in the downward direction and signals a downtrend.
Let’s refer again to Apple’s stock chart for an example:
You’ll notice a series of blue lines in the MACD section at the bottom of Apple’s stock chart.
In mid-November, a series of blue bars emerged in an upward direction from the center of the chart, suggesting that prices would rise. In mid-December, the bars reversed direction, falling below the zero line, suggesting prices would decline. Following these events, Apple’s stock price did exactly what the signals suggested would happen.
Bullish signals were also created in late January and mid-March of 2022, and another bearish signal can be spotted in mid-February 2022. Take a moment to study the chart and note how the price of Apple’s stock reacted following these events.
Finally, MACD divergences are used to determine which direction an asset is likely to move in. A divergence takes place when the MACD doesn’t agree with the asset’s price movement.
For example, if the asset closes the day at a higher high but the MACD moves lower, the move is known as a divergence. Here’s what divergences tell you:
- Bullish Divergence. When a stock closes the day lower, but the MACD moves into the positive territory, this is known as a bullish divergence. The signal suggests that bearish momentum is slowing and buyers are flooding into the asset. As a result, the price of the asset should head in the upward direction.
- Bearish Divergence. When a stock closes the day at a new high, but the MACD moves into negative territory, it’s considered a bearish divergence. This move suggests bullish momentum is slowing and the bears are about to take control. As a result, declines are likely ahead.
Let’s return to Apple’s stock chart to see what this looks like:
The MACD line started moving downward in mid-December. While the histogram showed bearish momentum, the price of Apple continued to move upward for a few trading sessions. As the divergence between the price of Apple and its MACD grew, a clear reversal began to emerge, leading up to dramatic declines in the price of the stock in the sessions to follow.
Toward the end of the chart, there’s a bullish divergence, with Apple’s 50-day moving average moving downward while the histogram moved into positive territory. Can you spot it? When you do, you’ll see the stock made a strong move for the top shortly following the divergence.
Relative Strength Index (RSI) vs. the MACD Indicator
The relative strength index (RSI) is a momentum indicator, just like the MACD. However, the two are calculated in different ways, which can lead to different results from time to time.
The RSI is also an oscillator, but it’s centered around price gains or losses over time, focusing on extreme highs and extreme lows to determine if an asset is overbought or oversold. This differs from the MACD because it doesn’t use moving averages to determine momentum and momentum direction.
No single momentum oscillator is perfect. Many traders use both the RSI and the MACD when making their trades, using one to verify the results of the other.
Limitations of the MACD Indicator
The MACD indicator is an impressive tool, but like most other technical analysis tools, it’s not perfect. Some limitations to consider when taking advantage of the MACD include:
- Failure to Signal. Although the indicator is great at showing when some reversals are likely to occur, it doesn’t catch them all. In some cases, momentum and price movements occur at just about the same time, and the MACD doesn’t have time to alert traders to the coming reversal before it’s already happened.
- False Positives. In some cases, momentum will shift directions for a short period and reverse quickly, while the price stays relatively flat. As a result, traders may act on a signal, and a reversal may not actually happen.
In short, the indicator doesn’t catch all reversals, and some of the signals it does provide won’t come to fruition.
Most indicators have their limitations, which is why it’s important for traders to have multiple tools in their toolboxes.
The MACD is an important piece of many successful traders’ trading strategies. The metric helps to determine when prices will rise and fall, but it isn’t perfect. Make sure you couple it with a few other technical indicators to get a full picture when making your moves in the market.