Moving Average Convergence Divergence Analysis
What Is Technical Analysis
Technical analysis is the scientific study of financial markets and their movements. It is a form of applied social science and the basis for many financial trading strategies. Technical analysis assumes that everything is known by the market or soon will be and that knowledge is represented by price action. Trends and market reversals can both be predicted with some accuracy using technical analysis momentum indicators like MACD.
What Is MACD
MACD, or Moving Average Convergence Divergence, is a technical analysis momentum indicator used to analyze financial markets. The indicator, like the name suggests, measures the convergence and divergence of moving averages. The tool is well respected and used in many markets. MACD is a useful trend and momentum indicator for forex, stock, bond, options, index and binary options trading.
The basics of MACD - MACD uses two moving average, a shorter one and a longer one. It can generate several different signals including trend determination, trend strength, support/resistance levels and potential market reversals. On its own MACD is a useful tool but when combined with another indicator, such as Stochastic, it becomes highly effective.
How To Calculate Moving Average Convergence Divergence
MACD is calculated using two exponential moving averages that are then smoothed by a third moving average. The indicator works well in all time frames and can be used with EMA's of varying length. The standard format for MACD, which can be displayed as a histogram or as an oscillator, is (12,26,9). This means the shorter term EMA is 12 bars, the longer term EMA is 26 bars and is smoothed by a 9 bar EMA. The smoothing period is important to alleviate whipsaws and false signals. The longer term moving average is also called the signal line. When the short term EMA crosses above the long term EMA (in an uptrend) it is giving a buy signal. When the short term EMA crosses below the long term EMA (in a downtrend) it is giving a sell signal.
Where Do You Find MACD
MACD is a tool offered by nearly every trading or charting platform I know. It is one of the most widely used and well respected technical indicators and the basis for many trading systems and strategies. At heart MACD is an oscillator but it can be displayed in two ways, regular MACD and the MACD histogram. The regular MACD indicator displays the two moving average in much the same way as other oscillators, moving above and below zero. The two moving averages tend to track each other but the shorter one will also move above and below the longer moving average and in that way gives buy and sell signals.
MACD Histogram - The MACD histogram, which is my preferred method of using this tool, measures the difference between the two moving averages and displays that value in histogram form, moving above and below zero as the shorter moving average moves above and below the longer moving average.
Reading The MACD Histogram
When the MACD histogram is above zero this considered to be bullish. When the histogram is below zero this is considered to be bearish. MACD will make bullish and bearish peaks regardless of market direction. A simple change of momentum does not signal a market reversal and should not be taken as a signal of such.
MACD Convergences Signal Trend Strength
About Thomas Hughes
Mr. Hughes has been a student of technical analysis and active trader for over 8 years. He uses MACD in conjunction with other indicators to speculate market movements of the major US indexes, foreign exchange markets, commodities and futures.
MACD Trading Systems
MACD trading systems using the indicator in several ways to generate signals and confirm price movement. The top three methods of MACD Analysis are extreme swings, convergences and divergences.
- Extreme swings - when plotted over time the MACD histogram will move in a range above and below zero. Occasionally, MACD will make a make a peak that is higher/lower than those that came before. This is called an extreme swing and is a useful method of MACD analysis. It can help predict market bottoms, impending reversals and possible breakouts.
- Convergence - When price action is trending either up or down MACD will make a series of peaks in tandem with the underlying asset. In an uptrend, if the MACD makes a series of higher peaks while the market makes a series of higher peaks this is called a bullish convergence and signals market strength. The same is true in reverse. If the markets are trending down and MACD makes a series lower peaks this is a bearish convergence and also signals strength (of a down trend).
- Divergence - Divergences occur when the MACD peaks do not make successively higher, or lower, peaks while the markets are trending. This is signaling weakness and can be used to predict potential resistance areas, impending market reversals or to confirm trading ranges.
MACD Histogram Divergence Signals Trend Weakness
MACD Divergence Indicator And Divergence Trading
MACD, especially the MACD histogram, is a great way to measure and trade divergences. However, MACD by itself is not enough to generate a good, reliable signal. MACD divergences give the best signals when used in conjunction with other forms of analysis such as trend lines, support/resistance, Fibonacci Retracement, candle charts or other price action analysis. When price action approaches a possible area of reversal such as a long term support line, long term moving average, trend line or retracement level look to MACD to confirm or refute that line. What I mean is this; if MACD is converging with price and showing a strong market it is more likely for price to move through the target level, if MACD is diverging from price and showing weakness it is more likely for price to be halted at the target level. One note of caution; it is important to wait for confirmation signals in price action before entering into a trade based on convergence/divergence theory.
Looking at the chart to the right we can see that price has moved above a long term trend line. The MACD oscillator is confirming the uptrend but the MACD Histogram while forming a bullish peak, is showing a divergence. At this level, especially with the market extended well above the 30 day EMA, price action is extended and susceptible to reversal. However, without a confirmation such as a bearish candle signal or move below the trend line it is not advisable to enter a trade based on this analysis.
MACD Divergence is best viewed as a hint of impending reversal. It is not a signal to change market posture. When divergences appear it may be time to take profits or buy protection. Divergences on longer term charts are more reliable than those on shorter term charts. A convergence of divergence, that is divergences appearing on more than one time frame, are even more reliable.