Technical Analysis Indicator - MACD - Moving Average Convergence/Divergence

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What is MACD?

MACD (Moving Average Convergence/Divergence) is supposed to reveal changes in the strength, direction, momentum, and duration of a trend in a stock's price.

The MACD indicator is a collection of three time series calculated from historical price data, most often the closing price. These three series are:

• the MACD series proper, which is the difference between a "fast" (short period) exponential moving average (EMA), and a "slow" (longer period) EMA of the price series,
• the "signal" or "average" series, which is an EMA of the MACD series itself, and 
• the "divergence" series which is the difference between the two. 

The MACD indicator thus depends on three time parameters, namely the time constants of the three EMAs. The notation "MACD(a,b,c)" usually denotes the indicator where the MACD series is the difference of EMAs with characteristic times a and b, and the average series is an EMA of the MACD series with characteristic time c. These parameters are usually measured in days. The most commonly used values are 12, 26, and 9 days, that is, MACD(12,26,9). 

Since the MACD is based on moving averages, it is inherently a lagging indicator. As a metric of price trends, the MACD is less useful for stocks that are not trending (trading in a range) or are trading with erratic price action.

Why 12, 26, 9?

As true with most of the technical indicators, MACD also finds its period settings from the old days when technical analysis used to be mainly based on the daily charts. The reason was the lack of the modern trading platforms which show the changing prices every moment. As the working week used to be 6-days, the period settings of (12, 26, 9) represent 2 weeks, 1 month and one and a half week. [2] Now when the trading weeks have only 5 days, possibilities of changing the period settings cannot be overruled. However, it is always better to stick to the period settings which are used by the majority of traders as the buying and selling decisions based on the standard settings further push the prices in that direction.

How to interprete MACD?

• Signal-line Crossover 

This occurs when the MACD and average lines cross, i.e. when the divergence (the bar graph) changes sign. A "bullish crossover" happens if the MACD line crosses up through the average line. A "bearish crossover" happens if the MACD line crosses down through the average line.

• Zero Crossover

This occurs when the MACD series changes sign, i.e. the MACD line crosses the horizontal zero axis. A change from positive to negative MACD is interpreted as "bearish", and from negative to positive as "bullish". Zero crossovers provide evidence of a change in the direction of a trend but less confirmation of its momentum than a signal line crossover.

• Divergence

A "positive divergence" or "bullish divergence" occurs when the price makes a new low but the MACD does not confirm with a new low of its own. A "negative divergence" or "bearish divergence" occurs when the price makes a new high but the MACD does not confirm with a new high of its own. 

MACD False Signal?

Like any forecasting algorithm, the MACD can generate false signals. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock. A false negative would be a situation where there was no bullish crossover, yet the stock accelerated suddenly upwards.

A prudent strategy may be to apply a filter to signal line crossovers to ensure that they have held up. An example of a price filter would be to buy if the MACD line breaks above the signal line and then remains above it for three days. As with any filtering strategy, this reduces the probability of false signals but increases the frequency of missed profit. Analysts use a variety of approaches to filter out false signals and confirm true ones.