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What is the best use of the MACD?

One of the challenges with all the charting and technical analysis tools is which tool to use for what purpose. In this article, we will be looking at what is the best use of the MACD. The MACD stands for Moving Average Convergence Divergence. It is one of the price signals used in technical analysis. It is the kind of price signal that is also referred to as an oscillator because the indicators in the MACD oscillate above and below zero depending on how price changes unfold over time.

For a general introduction into technical analysis, check here.

First, let’s look at the components and then the definition of the MACD.

MACD

Moving averages

One factor to note for moving averages is that we use exponentially weighted moving averages. The most recent values in the series have a larger effect on the moving average and the oldest values in the series have the least effect. The reason we do that makes sense if we consider the case of a 10-day moving average.

Remember that for a 10-day moving average we would typically use the closing price on each day to calculate the average.

If the closing price on each of the ten days had an equal weighting in the resultant moving average, imagine what would happen if there were a large price change between day 9 and day 10 and the price has since settled to a steady level. That large price change would be included in the moving average until such time as the ten-day series moves forward a day and no longer includes that big price change.

If all ten days were given equal weight in the average then that would show up as a big change even though the price is currently steady. That would just look strange, so the MACD uses weighted averages.

For the MACD, exponential rather than linear weighting is used as experience shows this to achieve the best smoothing effect. Typical weightings are shown graphically below.

12 and 26 days, 9 days and a histogram

The MACD was first introduced in the 1970s when the stock market was open six days a week and only daily prices were published.

The MACD uses moving averages with 9 days representing one and a half weeks, 12 days representing two weeks and 26 days representing a month. These remain the most popular periods in use today. Since many traders are using the MACD with these periods to establish buying and selling points, this fact in its own right drives price movements.

That is actually a bizarre phenomenon when you think about it. A tool set up to study price movements in the market actually ends up being a factor in driving price movements.

How it is calculated

The MACD is calculated from the 12-day exponential moving average which is the fast-moving average and the 26-day exponential moving average which is the slow moving average. The slow i.e. the 26-day average is subtracted from the fast i.e. the 12-day average and the result is a line referred to as the MACD line.

The MACD line is displayed along with the 9-day moving average which is referred to as the signal line.

The MACD is also usually displayed with a histogram that measures the magnitude of the difference between the MACD line and the signal line. The histogram itself oscillates above and below zero. If the MACD line is above the signal line then the histogram is shown above its zero value. If the MACD line is below its signal line then the histogram is shown below its zero value.

Here’s what the two lines and the histogram look like.

MACD basic

In this example, the histogram coloring matches the candlestick. In other words, when the stock price closed lower than the opening price and is displayed in red, the histogram for that day is also shown in red, and vice versa is shown in green when the price rose that day.

Crossovers

There are two kinds of crossovers that the MACD model provides.

Firstly there are the times when the MACD line crosses its own zero line. Effectively this is when the slow moving average and the fast-moving average are the same. When the MACD line crosses from negative territory to positive that is an indication of strengthening upward price momentum. When the MACD line crosses from positive to negative territory that is an indication that downward price momentum is strengthening.

Then there are crossovers between the MACD line and the signal line.

When the MACD line crosses the signal line from below to above that is a bullish price indicator, and hence a potential buy signal. When the MACD line crosses the signal line from above to below that is a bearish price indicator and a potential sell signal.

Both kinds of crossovers are seen on the chart from earlier, as below.

MACD crossovers

As the name suggests the MACD is all about the longer-term moving average converging or diverging with the shorter-term moving average and how that lines up with price movements.

Divergence

We start by watching the stock price.

If we see the stock price hitting a new low but the MACD does not hit a new low or in other words, it hits a higher low this is a bullish divergence and is an indicator that the downward movement in stock price could reverse and we are about to see a stock price rally.

On the other hand when the stock price hits a new high but the MACD line does not confirm this with a new high or its own, in other words, the MACD line hits a lower high that is a bearish divergence and indicates that the stock price upward movement is likely to reverse.

Convergence

The MACD is converging when the MACD line is moving towards its zero centerline. Remembering that this just means the fast and slow-moving averages are moving closer to each other then whatever price momentum we are seeing, whether up trending or down trending, is weakening.

MACD buy and sell signals

Let’s look and what some simple basic signals from the MACD would have told us about the Standard and Poor’s 500 index during the months when we saw dramatic and rapid price movements, between February and June 2020.

Here is a chart of the State Street SPDR ETF that goes by the symbol SPYwhich tracks the Standard and Poor’s 500 index  for that period

SPY Feb to June 2020

The chart shows the massive sell-off that started at the beginning of March and hit bottom on 23 March then to steadily climb back up nearly regaining all its lost ground until early June.

With the wisdom of hindsight, we could allow ourselves to fantasize about some ideal points to have bought and sold during those significant price movements. Assuming we were trading in weeks rather than days, we might have opted for the price points shown here.

SPY Feb to June 2020 ideal buy and sell points

OK, we could have been more aggressive and identified other price ranges that could have been profitably traded such as those shown here.

SPY Fed to June 2020 trading opportunities

But frankly, in light of the volatility we were experiencing, I wouldn’t have had the nerve to have tried that on any appreciable scale that is.

So taking what we learned from the MACD possible buy and sell signals, here are the points where we could have made those moves.

SPY Feb to June 2020 MACD buy and sell

To be thorough and rigorous we should really be examining the actual price points where we would have acted if we were taking signals from the MACD but just on the visual evidence, to my eye that would have been some pretty good buy and sell moves to have made.

Limitations

Notwithstanding the above, because the MACD is oscillating around a centerline determined by averages, it is a good indicator of momentum within a price trend it is not a strong indicator of when markets are significantly over-bought or over-sold.

Also, the fact that the MACD uses moving averages means that the indicators it generates have inherent lag. Thus, MACD indicators tend to be more reliable when stock prices are trending within a range.

This is the generally accepted wisdom, that:

The MACD is best used as an indicator of trending momentum within a price range.

We can conclude that the MACD is best used together with other tools that do a better job of indicating over-bought or over-sold markets and hence the likelihood of price trend reversals.

To find out more about the Moving Average Convergence Divergence, check here.

Here is a summary of the Moving Average Convergence Divergence you can download as a PDF here.

MACD summary


I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons and share it with your friends. They may just thank you for it


Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as investment advice, good or bad.


Affiliate Disclosure: This article contains affiliate links. If you click on a link and buy something, I may receive a commission. You will pay no more so please go ahead and feel free to make a purchase. Thank you!


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18 Comments

  1. Hi, Andy most people want to make quick money and they invest money in a bad way. And people take a wrong direction and lose their money Your article is going to advise how to invest well and how to handle technical analysis. Because you are expert in this field thanks for your lessons. And your articles

    • Hi Fireenaz and thanks for your comment and your positive feedback. I am glad that you found the article interesting. Best regards, Andy

  2. I loved the information you shared here. I recently got into trading and I can say that I’m a beginner in this field. The MACD tool looks like it is relatively easy to use. At least reading off the graphs is much easier after your in detailed analysis.

     Thank you for explaining how this tool works. I have a question, how accurate is the analysis of this tool?

    I mean how sure you are investing in the information you got from this tool?

    Thank you.

    • Hi and thanks for your comment. I am glad that you found this interesting.

      Your question seems simple on the surface but actually there are many ways to answer it. There are many other tools in addition to the MACD that can be used and most online trading platforms will give you free access so you can bring these up on your screen for any stock, ETF, option, or whatever financial instrument you are looking to invest in or trade. As to whether the MACD is a reliable tool to take buy and sell signals from would depend very much on your investing or trading horizon and your risk tolerance. In this article, I sought to look at how the MACD would give buy and sell signals for a very liquid i.e. heavily traded ETF during a recent period when market movements have been dramatic. Somewhat to my surprise, the MACD gave reasonably good signals. It is important to bear in mind the limitations of the MACD. It is really only showing the strength of price momentum within a range. If you are a long term investor this may be sufficient if you have decided that your strategy is to buy and hold. If you are looking at the more intermediate-term then you need to concern yourself with market trend reversals so you need to look at indicators that give you a sense of whether a stock, a sector, and the market are heading into over-bought or over-sold territory. I will be publishing articles that look at other indicators that look for price trend reversals and consider relative strength.

      Thanks for your comment and question and I hope you come back to check this site again.

      Best regards

      Andy

  3. Wow! Quite an interesting topic here. To be honest, I never was truly a trader to use indicators, and learning how they really work has never been my forte. On the other hand, I like the fact that MACD can be used to drive some very profitable trades when it is well mastered and well used. This is really interesting and useful at the same time. Thanks so much for sharing

    • HI and thanks for leaving this comment. I am glad you found it interesting and I hope useful. Best regards, Andy

  4. Becoming really good at predicting price trend reversals can be a game-changer. And I know that this article is an excellent help for us with this. I’m just starting to dip my foot into technical analysis and I have learned a couple of things from your post. I also see you have a link for more content that I’ll continue reading. Thank you very much!

    • Hi and thanks for leaving this comment. I am glad you found it interesting and I hope useful. I will be posting more material that also dives deeper into other technical analysis tools shortly. I hope you do come back and please don’t hesitate to ask any questions or make any suggestions. Thanks and best regards, Andy 

  5. It seems you have a lot of knowledge on this which is truly amazing. Investing is a risky game and those that lose money the most probably don’t have a lot of knowledge on how to do it the right way. Though risky but with educated knowledge, you can always beat the odds of failing. 

    I have never made use of the MACD tool because I did not really have a lot of knowledge on it but from this post, it seems it can be quite easy to understand. I think this would be a perfect tool that can help define and plan future trades. I would like to give this a try.

    • Hi and thanks for the comment. I am glad you found the article interesting and I hope useful. The MACD gives a particular view on price momentum which can indicate where price might go. I would not rely on it too much as this is only one of the factors you need to consider. You should also watch volume for signs of institutional buying or selling. You need to know where the overall market is heading. And you need to know whether the stock you are watching is a leader in its sector and whether its sector is exhibiting relative strength or not. And more important than all of that is what your goals and risk tolerance are. As I say the MACD is only a small part of the overall picture. Thanks again for the comment and I wish you good luck. Best regards, Andy

  6. Hi Andy, great article about MACD. I usually use it in conjunction with EMA and RSI, and have had some success with it, although I am still very much a beginner when it comes to trading (I actually do spreadbetting). What I always find hard is deciding when to sell. It is usually more straightforward getting into a trade than it is getting out. How could I use MACD to better effect when working out sell points? I thought your point about traders using indicators like MACD actually influencing markets very interesting – I’ve always thought that markets were driven by big volume mega-traders with complicated proprietary algorithms, and that little fish like me are really just piggybacking on their activities.

    Many thanks, Teri.

    • Hi Teri and thanks for the comment.

      I have been researching a bit about spread betting myself. MACD, EMA, and RSI are definitely useful tools for determining when to get into a spread. As regards getting out of a spread to try to eliminate emotion from the picture you may want to set your exit point(s) before you get in. Use Fibonacci calculation from previous evidence of price support and resistance to work out once you have a price that has broken either support or resistance where the next level of either support or resistance is likely to be. And then set an exit point shortly before that. As a general rule, I would never want to get into a trade without knowing where I was going to exit if the market goes the way I want and where I am going to exit if the market goes against me.

      As regards your comment on the big fish driving the market, yes that is absolutely correct. Apparently today around 89 percent of the value of the market is in institutional hands leaving only 11 percent in the hands of individual investors. But the big fish also use the same models we do in addition to clever AI, machine learning, and whatever else they have up their sleeves. Also, they need to move such large sums that much of their buying and selling has to be done over time so they don’t move prices too much. So try as they might to move with stealth and hide their tracks they are not able to do so 100 percent.

      I also added another short article on the RSI a couple of days ago you might want to check.

      https://badinvestmentsadvice.com/relative-strength-indicator-calculation/

      Thanks again and best regards

      Andy

  7. Hi Andy, many thanks for a super response, very helpful. And I’ll check out your RSI article as well.
    Best wishes
    Teri

  8. Knowing what and how to invest your money is a very big decision to make by all traders, the mindset directed to it makes it either successful or fail, it’s good for people to understand that making money online requires patience and isn’t a rush. This article is really nice and teaches traders how to be wise in their decisions. Thanks for sharing, it’s really helpful.

    • Hi and thanks for your comment. I agree with you. The well worn saying – fool rush in where wise men tread with caution – is very apt. Thanks again and best regards, Andy

  9. The MACD indicator is actually a very active understandable and worthwhile indicator in the sense that it actually works very well. Having read this I now appreciate how the MACD is used and how it can point out trades. Though I am not really an indicator trader, I prefer other basic technical analysis tools and that is why I have not been using the MACD. However, I understand now that the MACD is better than I thought.

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