MACD is a calculation mainly used as part of technical analysis for stock investments. MACD or Moving Average Convergence Divergence is an oscillator that helps in identifying the strength of a trend and of a possible reversal. This calculation method uses moving averages to arrive at the oscillator values, converting three moving averages into two.
While selecting stock market investments, MACD acts as a technical indicator for plotting future price trends of stocks.
How to calculate MACD?
The MACD indicator comprises three aspects:
- The MACD line – estimates the distance between two moving averages
- The signal line – identifies price momentum changes and triggers buy and sell signals
- The histogram – difference between the MACD and the signal line
For calculating Moving Average Convergence Divergence, we must subtract the long term EMA from the short term EMA. Here are the MACD formulas:
|1. MACD Line: (12-day EMA – 26-day EMA)|
This method considers 12 and 26 days exponential moving averages for constructing MACD lines. MACD is the difference between the two EMAs values – 26 periods and 12 periods.
2. Signal Line: 9-day EMA of MACD
LineSignal line is the nine-day EMA. Placed on top of the MACD line, it acts as a trigger for purchase and sale signals.
3. MACD Histogram: MACD Line – Signal Line
Steps for MACD calculation and plotting
As discussed above, MACD calculation mainly considers two lines:
- The MACD line
- The signal line
First, the MACD line is established by:
- Reducing the 26-period moving average from the 12-period moving average.
Second, the signal line is the 9-period moving average of the MACD
Lastly, the MACD is displayed as a histogram.
- This is a graphical representation of the total distance between the two lines.
- In case the MACD cuts through the signal line from below, traders consider it as a buy signal
- If MACD cuts the signal line from above, traders use it as a sell signal
- These intersections are called MACD crossovers
Benefits of using MACD
MACD indicator is widely used in the stock market analysis because
- it is simple and
- It is reliable
MACD enjoys popularity among those who perform a technical analysis of markets because of the two different signals in it:
- the strength of a trend and
- the turning point of a trend.
MACD is not just about determining an upward or downward trend. It also tells us about the strength of buy and sell signals.
If a trader uses a simple moving average to know to buy and sell signals, it can be delayed as the market conditions may change before the execution of the trade. This is where the moving average convergence/divergence indicator comes into the picture as it allows an up-to-date market movement representation.
What are the flaws of MACD analysis?
Just as any indicator, the MACD comes with some flaws and should ideally be used in parallel to other technical analysis methods.
One drawback of MACD is that it acts as a short-term indicator. This is because the longest measurement that it can consider is the 26-day moving average. Therefore, if a trader has a longer-term outlook, the MACD may suit his/her requirements.
MACD is also trend-following since it provides signals only when a trend occurs, never before it is about to start. Therefore, if a trader wants to recognize an upcoming trend, the MACD cannot be of any use.
The MACD indicator is very useful in technical analysis, as it brings together momentum and trend under one indicator. Developed by Gerald Appel, this method is known to be one of the easiest and effective momentum indicators. However, investors must remember that comparing MACD values for a group of securities that have varying prices is not possible. It should also not be used as an indicator for overbought and oversold levels.
Technical analysis of stocks involves studying historical market data, price and volume changes to determine stock market entry and exit. With the use of fundamental and technical analysis, analysts and investors try to use past performance data for predicting future market patterns.
Fundamental analysis makes use of publicly available data for evaluating the value of a stock or other security. It uses data such as revenues, earnings, return on equity, profit margins, future growth, etc, to determine the underlying value and potential that a company carries.
Technical analysis is based on three principles, including, all important information on a stock is reflected in its price, stock prices move in trends, and history often repeats itself in the stock market scenario.
Some of the commonly used tools in technical analysis are charts, moving averages, and momentum indicators.
Technical analysis helps stock market investors make sound investment decisions by identifying support and resistance levels. It allows investors to time their actions while understanding demand and supply.