Moving Average Convergence Divergence

MACD, or moving average convergence divergence, is one of the technical analysis’s most widely used momentum indicators. Gerald Appel created this around the end of the 1970s. This indicator calculates the difference between two time period phases, a compilation of historical time series, to determine momentum and its lateral strength. 

What is Moving Average Convergence Divergence exactly?

In moving average convergence divergence (macd), usage of ‘moving averages’ of two independent time intervals happens on historical closing prices of securities. By subtracting the two moving averages, you get a momentum oscillator line, known as ‘divergence.’ The basic principle for taking two moving averages is that one must be lesser in time. The other should be lengthier in time. For this reason, usage of exponential moving averages (EMA) is more common. 

The key features of a moving average convergence divergence (macd) indicator are as follows: 

a) Period or interval – Users define this interval. The following are some examples of commonly used periods:
i. Short-term intervals — 3, 5, 7, 9, 11, 12, 14, 15-day intervals. Though, 9-day and 12-day intervals are most popular.
ii. Long-term intervals include 21, 26, 30, 45, 50, 90, and 200-day intervals; the 26-day and 50-day periods are the most common.

b) MACD Line or Momentum oscillator line or divergence – This is as basic as a depiction of ‘divergence’ or the difference between two interval moving averages.

c) Signal Line – Signal Line is an exponential moving average of divergence data, such as the 9-day exponential moving average (EMA).

d) Normally, usage of a combination of the 12-day and 26- day EMAs of prices and the 9-day EMA of divergence data happens, although you can adjust these values based on the trading aim and variables.

e) You can see the previous data is on a chart then, with the X-axis representing time and the Y-axis representing price. To obtain the MACD line, signal line, and the presentation of statistics for the difference between the MACD signal line will be below the X-axis.

Moving Average Convergence Divergence Formula

The moving average convergence divergence series is a processed indicator of the derivatives of the input (price) sequence concerning the time in signal processing terminology. In technical stock analysis, the result is “velocity.” MACD estimates the derivative as if two low-pass filters were calculated and then filtered together, a “gain” equal to the difference in their time constants multiplied. 

You can also observe that it approximates the derivative as if a single low pass exponential filter (EMA) computed and then filtered it with a time constant equal to the sum of the two filters’ time constants multiplied by the same gain.

As a result, with the conventional moving average convergence divergence – macd filter time constants of 12 and 26 days, the equivalent of a 38-day low-pass EMA filter roughly filters the MACD derivative estimate. The MACD value divided by 14 yields the time derivative estimate (per day).

The average series is a derivative approximation, too, with a low-pass filter added in combination for extra smoothness (and additional lag). The divergence series (the difference between the MACD and average series) serves as a measure of the second derivative of value concerning the time (“acceleration” in technical stock analysis). This estimate includes the signal filter’s additional latency and an added gain factor equivalent to the signal filter constant.

Learning From MACD

When the 12-period EMA (outlined by the red line on the price graph) is above the 26-period EMA (shown by the blue line on the price chart), the MACD has a positive value (used as the blue line in the lower graph). 

A negative value when the 26-period EMA (indicated by the blue line in the price chart) is above the 12-period EMA. The greater the MACD’s distance above or below its baseline, the more significant the gap between the two EMAs.

Crossing the Signal Line

The most typical MACD signals are signal line crossings. The signal line is the MACD line’s 9-day EMA. It follows the MACD as a moving average of the indicator, making it more straightforward to notice MACD turns. When the MACD rises and crosses just above the signal line, it is a bullish crossing. This is a bearish crossing when the MACD falls and crosses under the signal line. Depending on the severity of the exercise, crossovers might endure a few days or weeks.

Before depending on these standard signals, tread cautiously. You should cautiously approach the crossovers of signal lines at positive or negative extremes. Even though the MACD has no upper and lower bounds, technical analysts can calculate historical peaks with a basic visual inspection. The underlying security must make a big move to drive momentum to an extreme. Even if the movement continues, velocity will likely reduce, resulting in a signal line crossing at the extremities. The frequency of crossings might also be increased by instability in the underlying investment.

Limitations of MACD

A significant issue with the moving average convergence divergence is that it can prompt a reversal, but it may never happen. It’s not a perfect indicator and can create many false positives. Another issue is that it’s unable to predict all reversals. To simplify, the MACD can make multiple false reversals that never happen while not providing information when an actual market reversal occurs. In a way, it’s not always reliable in a market reversal.

The false-positive occurs when the price doesn’t fluctuate and moves sideways like in a range or triangle pattern. A slowdown in momentum of the share, like a slow trading moment, can cause the MACD to move towards zero leaving its extremes behind, showcasing a reversal even though it may never occur.  

MACD vs. Relative Strength

The relative strength indicator (RSI) indicates whether a market is overbought or oversold regarding current price levels. The RSI is an indicator that computes the average price gain and loss over a particular period. The period is set to 14 by default, with 0 to 100.

The MACD evaluates the connection between two exponential moving averages (EMAs), whereas the RSI gauges price movement regarding recent prices up to and downs. These two indicators are frequently employed together to offer analysts a more comprehensive technical overview of a market.

These indicators both indicate market momentum, but they can occasionally produce contradictory results because they measure distinct parameters. For example, the RSI may display a reading over 70 for a lengthy period, suggesting that the market overextends to the buy-side about current prices. Yet, the MACD indicates that the market’s purchasing momentum is still building. By displaying divergence from price, any indicator may indicate an impending trend shift (price increases when the indicator goes lower, or vice versa).

Conclusion

A divergence occurs when the moving average convergence divergence – macd generates highs or lows that differ from the associated ups and downs on the price. This is a positive divergence when the MACD creates two extreme lows corresponding to two dropping lows in the price. When the long-term trend remains positive, this is a reliable bullish indication.

Even if the long-term trend is negative, some traders may seek bullish divergences since they can herald a shift in the direction; however, this strategy is less accurate.

A bearish divergence occurs when the MACD establishes a series of two declining highs that correspond to two rising highs in the price. A bearish split during a long-term bearish trend indicates that the trend will likely persist.

Some traders may look for negative divergences amid long-term bullish trends since they might indicate trend weakness. However, it is not as trustworthy as a negative divergence during a negative trend.