What is the MACD
The abbreviation of MACD stands for Moving Average Convergence Divergence. This is one of the lagging indicators available in stock trading. For this reason the MACD has a trend confirming character. Traders use this indicator to attain signals, affirming the presence of a price tendency.
The MACD indicator is generally displayed at the bottom (or the top) of your chart and stays separately from the pure price action. Below you will find an image, showing an MACD indicator.
The image shows a standard 5-minute chart of the Chevron stock. The lower part of the image is the MACD indicator, which is enlarged, so you can get a closer look on it.
MACD Indicator Calculation
As you see the MACD trading tool consists of couple of lines and a histogram. Many stock traders confuse the two lines with ordinary Moving Averages, which smooth the general price action. This is absolutely incorrect. Yes, the two lines are Moving Averages but not of the price action.
The default parameters of the Moving Average Convergence Divergence tool are 9, 26, 12. We will now explain you why. There is a faster and a slower line on the indicator. Let’s analyze each of these two lines:
Faster MACD Line
The faster line of the indicator is also called the MACD line. We calculate the MACD line by plotting a 12-period Exponential Moving Average and then subtracting a 26-period EMA from it:
MACD Line = (12-period EMA – 26-period EMA)
If the 12 EMA on the Facebook stock gives you a value of $100 per share and the 26 EMA value gives you $99.76, then the MACD line of the indicator will point to 100.00 – 99.76 = 0.24.
The slower line on the MACD indicator is called Signal Line. Since it is slower, the MACD line constantly breaks it upwards and downwards. To calculate the Signal Line of the MACD indicator you should simply smooth the MACD line by a 9-period EMA:
Signal Line = 9 EMA on the MACD Line
The MACD histogram simply illustrates the difference between the MACD line and the Signal Line. The higher the MACD histogram is, the bigger the difference between the two MACD lines is.
You are looking at an image, which points out the three components of the MACD tool. These are the MACD Line, the Signal Line and the Histogram.
Since you are now familiar with the structure of the MACD indicator, we will now go over the different signals and how you can use them in trading.
This is the basic signal you can find on the indicator. Crossover appears when the MACD line breaks the Signal Line. The function of the MACD crossover is to give you a signal in the direction of the cross. Since the histogram displays the difference between the two lines, a crossover switches the histogram values from negative to positive and the opposite.
The MACD indicator is bullish when the MACD line is above the Signal Line and the distance between the two lines is increasing. In this manner, the MACD histogram is closing higher positive periods.
This MACD state is opposite to the bullish MACD. We have a bearish MACD when the MACD line is below the Signal Line and the distance between the two lines is increasing. In this case the histogram is showing lower negative periods.
Above you see a Zoom-In image of the MACD trading tool. The picture shows two bullish and two bearish phases of the indicator.
The divergence by the MACD indicator acts the same way as with other add-on indicators.
Bearish Divergence – Price increases, but MACD lines give lower tops and bottoms. Bearish divergences signalize for potentially strong bearish movement.
Bullish Divergence – Price decreases, but MACD lines give higher tops and bottoms. Bullish divergences give signals for potentially strong bullish move.
The chart above shows a case of a bearish divergence between price action and the MACD. The pink lines show that the MACD creates lower tops while price on the chart increases. We see a rapid bearish movement afterwards.
Overbought and Oversold Values
Yes, the MACD indicator, similar to the RSI in this aspect, can signalize an overbought and oversold market. Many stock traders are not familiar with this signal of the MACD. For this reason, I will now introduce you the oscillating function of the Moving Average Convergence Divergence:
Overbought Stock – MACD line gains significant bullish distance from the Signal Line. When the stock is overbought, we get a bearish signal.
Oversold Market – MACD line gains significant bearish distance from the Signal Line. When the stock is oversold, we get a bullish signal.
The image above displays a classical overbought signal coming from the MACD indicator. After the price increase and the overbought signal, we observe a consistent price drop.
Trading with the MACD Indicator
Since you are now familiar with the MACD structure and its signals, we will now demonstrate a couple of trading cases including this indicator.
Above you see the 5-minute chart of Netflix for May 6, 2016. The image displays a long position with the NFLX stock, provoked by a classical bullish crossover of the MACD lines. The interesting here is that the MACD line attempted to break the Signal Line in the middle of the trade. However, the MACD line bounced from the Signal Line and we stayed in the trade.
The long NFLX trade led to a profit of $1.00 per share, which equals to 1.12% increase in the invested amount in the trade.
Let’s now approach another trading case with the MACD indicator.
Now we are looking at a bullish divergence trade on the 5-minute chart of Yahoo for Apr 5, 2016. The divergence is indicated by the pink lines on the chart. As you see, the price action is moving downwards, while the MACD lines are increasing.
In order to trade an MACD divergence, we would need to demonstrate some basic price action trading skills. The black horizontal channel on the chart indicates a price range, which comes right after the decrease. We use the upper level of the range as a trigger line for our long trade. When the price closes a candle above the upper level of the range, we buy the YHOO stock. We stay in the trade until the two MACD lines do a bearish crossover.
This is another profitable trade with the MACD indicator which leads to profit of 1.51%.