Moving Average Convergence and Divergence (MACD)
In the late seventies, Gerald Appel created the renowned Moving Average Convergence and Divergence (MACD) indicator. MACD is widely seen as a pioneering indicator amongst traders and has retained its respectability as one of the most dependable momentum indicators even now, several decades later.
MACD is about the intertwining of two moving averages. The averages move in tandem when converging and drift apart when diverging.
To determine a MACD, we employ 12-day and 26-day exponential moving averages (EMAs). Primarily based on closing prices, the 12 EMA is then deducted from the 26 in order to calculate the convergence/divergence (CD) value. This line graph of such is usually referred to as the ‘MACD Line’. Before we discuss its applications, let’s go over the mathematics behind it.
Let us understand the table, beginning on the left.
By calculating the MACD value over 12 and 26-day EMAs and plotting it as a line graph, we obtain the MACD line, which fluctuates above and below the baseline.
Using the MACD value, let’s look for answers to some key questions.
The sign of the MACD shows the way the stock is likely to move. If the 12 Day EMA is 6380, and the 26 Day EMA is 6220, then the MACD value will be +160. In what situation could the 12-day EMA be greater than the 26-day?
We discussed this in our segment on moving averages; it happens when there is an upward bias in a stock’s price.
The shorter-term average tends to incorporate recent news and market movements more quickly than its long-term counterpart. Whenever there’s a positive sign, that implies that there are positive forces at work wherein the stock could move up. The magnitude of this momentum can be measured by the figure associated with MACD; for instance, a bigger number like +160 implies a larger uptrend as opposed to +120.
When dealing with the magnitude, be mindful that the stock’s price is related to it. The higher the underlying price, such as Bank Nifty, the larger will be the MACD’s magnitude.
When the MACD is negative, it indicates the 12-day EMA is lower than the 26-day EMA, meaning the momentum is decreasing. As well, a larger magnitude of MACD reveals a stronger downward trend.
The difference between the two moving averages is known as the MACD spread. When momentum slows down, this spread diminishes, and when it grows stronger, it increases. To monitor convergence and divergence, traders typically chart the MACD value – commonly referred to as the MACD line.
Traders often contend that by the time the MACD line intersects the centerline, a bulk of the move can be missed out on. To circumvent this issue, an extra element to MACD is added – the 9-day signal line. This 9-day signal line is basically an exponential moving average (EMA) of the MACD line. Thus, it provides two indicators instead of one.
With this two-line crossover strategy, traders no longer have to wait for a centerline cross-over when employing moving averages, as discussed in the prior chapter.