The MACD Indicator (Moving Average Convergence Divergence) measures the relationship between two moving averages in stock price. What does this mean and how can the MACD indicator alert investors to new Bullish or Bearish trends?
Trend and Momentum: these are two concepts in the market that I like to watch closely. While we intuitively know what these ideas mean, how do we actually measure them within the framework of investing? We can take a look at a price chart of a stock, ETF or market index and get a good sense of what the trend is: up, down or sideways. But momentum is a bit harder to ascertain with simple ocular analysis. Additionally, we are all operating with different time frames in the market. One investor’s short-term uptrend could simply be a counter-trend rally within the context of a downtrend for another investor.
Thankfully, there are indicators that can help investors get a sense of the trend and momentum for their particular time frame and investment style. One that is extremely popular is the MACD indicator or Moving Average Convergence/Divergence Oscillator. The team at StockCharts.com provides a good description of the MACD:
Developed by Gerald Appel in the late seventies, the Moving Average Convergence/Divergence oscillator (MACD) is one of the simplest and most effective momentum indicators available. The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter one. As a result, the MACD offers the best of both worlds: trend following and momentum. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. The MACD Histogram represents the difference between MACD and its the signal line.
Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals. Because the MACD is unbounded, it is not particularly useful for identifying overbought and oversold levels.
The default settings for the MACD indicator are:
- Short-term Exponential Moving Average: 12 period
- Long-term Exponential Moving Average: 26 period
- Signal Line: 9 period Exponential Moving Average
The periods adjust for the period being shown on the chart: days, weeks, months, etc…
For those who are interested in the math behind the MACD indicator, the formula is readily available:
Here is a chart of the SPDR S&P 500 ETF (SPY) over the past year with the 12 and 26 day exponential moving averages:
We can clearly see that the trend for this time frame is up. But is there momentum behind the move higher? Is that momentum accelerating or decelerating? Enter the MACD indicator:
The black line is the MACD line, the difference between the two moving averages, which has been rising since the market made a low in March. The red line is the signal line, the nine period EMA of the MACD line. The blue histogram shows us the difference between the MACD line and the signal line. So what are we looking at? The MACD line bottomed and turned higher after the market made its low on March 23rd. This makes sense because moving averages are lagging indicators. Shortly after, the MACD indicator line crossed the signal line (a clue). Then the histogram turned positive (another clue / confirmation).
Turning back to the team at StockCharts.com we can begin to build a framework for interpretation:
- Signal line crossovers are the most common MACD signals. The signal line is an EMA of the MACD line. As a moving average of the indicator, it trails the MACD and makes it easier to spot MACD turns. A bullish crossover occurs when the MACD turns up and crosses above the signal line. A bearish crossover occurs when the MACD turns down and crosses below the signal line. Crossovers can last a few days or a few weeks, depending on the strength of the move.
- Centerline crossovers are the next most common MACD signals. A bullish centerline crossover occurs when the MACD line moves above the zero line to turn positive. This happens when the shorter EMA of the underlying security moves above the longer EMA. A bearish centerline crossover occurs when the MACD moves below the zero line to turn negative. This happens when the shorter EMA moves below the longer EMA.
- Divergences form when the MACD indicator diverges from the price action of the underlying security. A bullish divergence forms when a security records a lower low and the MACD forms a higher low. The lower low in the security affirms the current downtrend, but the higher low in the MACD shows less downside momentum. Despite decreasing, downside momentum is still outpacing upside momentum as long as the MACD remains in negative territory. Slowing downside momentum can sometimes foreshadow a trend reversal or a sizable rally.
Arguably, this is a short-term measure used by short-term traders. However, the time periods can be adjusted to fit your individual time-frame and investment style. Let’s say that you are an investor. You do not want to be caught up in the daily ebbs and flows of the market. Simply adjusting the period on the chart and the parameters of the indicator may help. Taking the chart to the weekly period, we will look at the 13 period EMA and the 26 period EMA to represent the three month and six month trends respectively.
A quick glance at the chart would tell us that the trend for this time frame is flat. Add in the MACD indicator and we can see that the MACD line is turning higher (trend beginning to rise?). The MACD line has crossed above the 4 period EMA signal line to provide initial confirmation.
The MACD indicator is a good tool to get a sense of both trend and momentum. Adjusting the chart period and indicator parameters makes it useful across time frames and investment styles. However, it is important to remember that there is no one perfect indicator. Investors should use any tool in conjunction with other metrics. For instance, investors can screen for MACD signals on stocks that are rated Very Bullish or Bullish in the 20-factor model at Chaikin Analytics to identify potential opportunities in stocks that are exhibiting solid fundamentals. If the stock also has strong relative strength, that would provide an additional bullish data point.