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MACD Indicator Explained/ And The best Step On How MACD works

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Moving average convergence divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.

MACD Indicator Explained

The moving average convergence divergence (MACD) oscillator is one of the most popular technical indicators. Though it is not useful for intraday trading, the MACD can be applied to daily, weekly, or monthly price charts. Traders use the MACD to identify when bullish or bearish momentum is high in order to identify entry and exit points for trades. MACD is used by technical traders in stocks, bonds, commodities, and FX markets.

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When the MACD line crosses from below to above the signal line, the indicator is considered bullish. The further below the zero line the stronger the signal. When the MACD line crosses from above to below the signal line, the indicator is considered bearish. The further above the zero line the stronger the signal.

About MACD

MACD, short for moving average convergence/divergence, is a trading indicator used in technical analysis of stock prices, created by Gerald Appel in the late 1970s. It is designed 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, the “signal” or “average” series. And the “divergence” series which is the difference between the two. The MACD series is the difference between a “fast” exponential moving average (EMA). And a “slow” EMA of the price series. The average series is an EMA of the MACD series itself.

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The MACD indicator

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). 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 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 weeks. 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.

The MACD and average series

The MACD and average series are customarily displayed as continuous lines in a plot whose horizontal axis is time, whereas the divergence is shown as a bar graph (often called a histogram).

A fast EMA responds more quickly than a slow EMA to recent changes in a stock’s price. By comparing EMAs of different periods, the MACD series can indicate changes in the trend of a stock. It is claimed that the divergence series can reveal subtle shifts in the stock’s trend.

Since the MACD is based on moving averages, it is a slow indicator lagging indicator. As a future metric of price trends, the MACD is less useful for stocks that are not trending (trading in a range) or are trading with unpredictable price action. Hence the trends will already be completed or almost done by the time MACD shows the trend.

Learning From MACD

The MACD has a positive value (shown as the blue line in the lower chart) whenever the 12-period EMA (indicated by the red line on the price chart) is above the 26-period EMA (the blue line in the price chart) and a negative value when the 12-period EMA is below the 26-period EMA. The more distant the MACD is above or below its baseline indicates that the distance between the two EMAs is growing.

In the following chart, you can see how the two EMAs applied to the price chart correspond to the MACD (blue) crossing above or below its baseline (dashed) in the indicator below the price chart.

MACD is often displayed with a histogram (see the chart below) which graphs the distance between the MACD and its signal line. If the MACD is above the signal line, the histogram will be above the MACD’s baseline. If the MACD is below its signal line, the histogram will be below the MACD’s baseline. Traders use the MACD’s histogram to identify when bullish or bearish momentum is high.

MACD Indicator Explained

The Moving Average Convergence Divergence (MACD) is an oscillator type indicator that is widely used by traders for technical analysis (TA). MACD is a trend-following tool that utilizes moving averages to determine the momentum of a stock, cryptocurrency, or another tradeable asset.

Developed by Gerald Appel in the late 1970s, the Moving Average Convergence Divergence indicator tracks pricing events that have already occurred and, thus, fall into the category of lagging indicators (which provide signals based on past price action or data). The MACD may be useful for measuring market momentum and possible price trends and is utilized by many traders to spot potential entry and exit points.

Before diving into the mechanisms 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 previous data during a predefined period. In the context of financial markets, moving averages are among the most popular indicators for technical analysis (TA) and they can be divided into two different types: simple moving averages (SMAs) and exponential moving averages (EMAs). While the SMAs weigh all data inputs equally, EMAs assign more importance to the most recent data values (newer price points).

How MACD works

The MACD indicator is generated by subtracting two exponential moving averages (EMAs) to create the mainline (MACD line), which is then used to calculate another EMA that represents the signal line.

In addition, there is the MACD histogram, which is calculated based on the differences between those two lines. The histogram, along with the other two lines, fluctuates above and below a centerline, which is also known as the zero line.

Therefore, the MACD indicator consists of three elements moving around the zero line:

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  • The MACD line (1): helps determine upward or downward momentum (market trend). It is calculated by subtracting two exponential moving averages (EMA).
  • The signal line (2): an EMA of the MACD line (usually 9-period EMA). The combined analysis of the signal line with the MACD line may be helpful in spotting potential reversals or entry and exit points.
  • Histogram (3): a graphical representation of the divergence 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.

1. The MACD line

In general, the exponential moving averages are measured according to the closing prices of an asset, and the periods used to calculate the two EMAs are usually set as 12 periods (faster) and 26 periods (slower).

The period may be configured in different ways (minutes, hours, days, weeks, months), but this article will focus on daily settings. Still, the MACD indicator may be customized to accommodate different trading strategies.

Assuming the standard time ranges, the MACD line itself is calculated by subtracting the 26-day EMA from the 12-day EMA.

As mentioned, the MACD Line oscillates above and below the zero line, and this is what signals the centerline crossovers, telling traders when the 12-day and 26-day EMA are changing their relative position.

2. The signal line

By default, the signal line is calculated from a 9-day EMA of the mainline and, as such, provides further insights into its previous movements.

Although they are not always accurate, when the MACD line and signal line cross, these events are usually deemed as trend reversal signals, especially when they happen at the extremities of the MACD chart (far above or far below the zero line).

3. The MACD histogram

The histogram is nothing more than a visual record of the relative movements of the MACD line and the signal line. It is simply calculated by subtracting one from the other:

However, instead of adding a third moving line, the histogram is made of a bar graph, making it visually easier to read and interpret. Note that the histogram bars have nothing to do with the trading volume of the asset.

How to read MACD charts

As the name suggests, the Moving Average Convergence Divergence indicator tracks the relationships between moving averages, and the correlation between the two lines can be described as either convergent or divergent. Convergent when the lines gravitate toward one another and divergent when they move apart.

Still, the relevant signals of the MACD indicator are related to the so-called crossovers, which happen when the MACD line crosses above or below the centerline (centerline crossovers), or above or below the signal line (signal line crossovers).

Keep in mind that both centerline and signal line crossovers may happen multiple times, producing many false and tricky signals – especially in regards to volatile assets, such as cryptocurrencies. Therefore, one should not rely on the MACD indicator alone.

1. Centerline crossovers

Centerline crossovers happen when the MACD line moves either on the positive or negative area. When it crosses above the centerline, the positive MACD value indicates that the 12-day EMA is greater than the 26-day.

In contrast, a negative MACD is shown when the MACD line crosses below the centerline, meaning that the 26-day average is higher than the 12-day. In other terms, a positive MACD line suggests a stronger upside momentum, while a negative one may indicate a stronger drive to the downside.

2. Signal line crossover

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 consider it a selling opportunity (exit point).

While the signal crossovers can be helpful, they are not always reliable. It is also worth considering where they take place in the chart as a way to minimize the risks. For instance, if the crossover calls for a buy but the MACD line indicator is below the centerline (negative). Market conditions may still be considered bearish.

Conversely, if a signal line crossover indicates a potential selling point. But the MACD line indicator is positive (above the zero line), market conditions are still likely to be bullish. In such a scenario, following the sell signal may carry more risk (considering the larger trend).

3. MACD and price divergences

Along with centerline and signal line crossovers. MACD charts may also provide insights through divergences between the MACD chart and the asset’s price action.

For example, if the price action of a cryptocurrency makes a higher high while the MACD creates a lower high. We would have a bearish divergence, indicating that despite the price increase. The upside momentum (buying pressure) is not as strong as it was. Bearish divergences are usually interpreted as selling opportunities because they tend to precede price reversals.

On the contrary, if the MACD line forms two rising lows that align with two falling lows on the asset price. Then this is considered a bullish divergence. Suggesting that despite the price decrease the buying pressure is stronger. Bullish divergences tend to precede price reversals. Potentially indicating a short-term bottom (from a downtrend to an uptrend).

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In Conclusion

When it comes to technical analysis, the Moving Average Convergence Divergence oscillator is one of the most useful tools available. Not only because it is relatively easy to use, but also because it is quite effective at identifying both market trends and market momentum.

However, if there is anything you think we are missing. Don’t hesitate to inform us by dropping your advice in the comment section.

Either way, let me know by leaving a comment below!

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