In the late seventies, Gerald Appel developed one of the most simple yet effective momentum indicators around — which is the Moving Average Convergence Divergence oscillator or MACD (mac-dee). Designed to identify shifts in the momentum, direction, strength and duration of price trends, the MACD is calculated by subtracting the 26-period EMA or Exponential Moving Average from the 12-period EMA — resulting in a MACD line.
Since all of the data used in MACD is based on past price action, this makes MACD a lagging indicator — which means the indicator only changes after the market does. Consequently, the MACD might be less suitable for assets that are not trending or with a highly unpredictable price action. That being said, some traders also use MACD histograms to predict when the trend will undergo a change. This aspect of the MACD might be seen as a leading indicator by these traders instead.
A nine-day EMA — which is plotted on top of the MACD line — is called a “signal line”. When the MACD crosses above its signal line, traders may see it as a good sign to buy the asset. On the other hand, when the MACD crosses below its signal line, it is seen as a sell signal. Thus, the signal line functions as a trigger for buy and sell signal. While there are various ways to interpret MACD indicators, the most common methods are crossovers, divergences, and rapid rises or falls.
First, let’s go over the Crossovers. If the MACD goes above the signal line, it is a bullish signal — indicating that the asset’s price might rise soon. Inversely, when the MACD goes below the signal line, it is a bearish signal suggesting that it may be time to sell. Some traders may play it safe and wait for the MACD to actually cross above the signal line for confirmation before entering a position. They do that to lower the risk of entering a position prematurely. When the MACD crosses above or below the signal line after a brief correction within a longer uptrend or downtrend, it is deemed as a bullish or bearish confirmation.
Next, let’s get to know about the Divergences. To look for divergences, we have to compare both the candlestick and MACD graphs. Now, notice how the highs or lows formed by the MACD diverge from the corresponding highs and lows formed by the price graph. This one in particular is called a bullish divergence, and it is a valid bullish signal if the long-term trend is still positive.
Conversely, when the MACD forms two consecutive falling highs that correspond to two rising highs on the price, this is called a bearish divergence. Similarly, it is a valid bearish signal if the long-term trend is still negative. It is not unheard of for traders to search for bullish or bearish divergences in spite of the long-term bearish or bullish trend since this can be taken as a signal for possible trend change. However, this method might be less reliable.
Last but not least, let’s talk about Rapid Rise or Fall. When the MACD experiences a steep rise or fall , it is a signal that the overbought or oversold asset will soon go back to a state of normalcy. The Relative Strength Index (RSI) or other technical indicators are commonly used in this kind of analysis to confirm overbought or oversold conditions.
The MACD histogram is often used the same way that traders may use the MACD itself. This is because the histogram also displays bullish or negative crossovers, divergences, and rapid rises or falls. However, bear in mind that some experience is required before one can choose between the signals on the MACD and its histogram due to timing differences.
