The Moving Average Convergence-Divergence indicator was developed as an attempt to try to create a reliable leading indicator out of two lagging indicators. This design in applying two trend-following moving average indicators to create the momentum oscillator that we know today as the MACD was the ingenuity of Gerald Appel during the 1970’s. The importance of this indicator has grown with increasingly accessible trading technology and it is now a standard feature of any charting software package. MACD is multi-functional for traders; it can be used to trade crossovers of the MACD and signal line, crossovers of the zero line and both hidden and regular divergence trades.
The MACD is made up of two lines: one indicator line and one signal line. It is displayed in an indicator window with a scale ranging from +1 to -1 with 0.0 in the middle, described as the zero line. Often the MACD will also be represented by a histogram, allowing the information that it conveys to be magnified and easier to view. The MACD indicator line is created by taking the difference between the 12 and 26 bar exponential moving averages (EMA’s). This is calculated by deducting the slower EMA from the faster EMA to give a single value which is then applied to form the MACD line on the indicator. This line can fluctuate above and below the zero line in the indicator window, showing when the two EMA´s are wide apart by moving further from the zero line on the scale.
Applied to this MACD indicator line is a signal line. This is an exponential moving average with a default value of 9, making it relatively sensitive to movements in price. It is known as the signal line because of its ability to offer trade entry signals whenever it crosses the MACD indicator line. The two lines together both converge and diverge; traders interpret the crossover of these two lines as potential trading opportunities. When the MACD indicator line crosses below the signal line this can represent a sell signal and when it rises and passes above it may be considered a buying opportunity. These signals, however, need to be filtered by their location on the scale as it would not be advised to trade these crossovers at either positive or negative extremes.
Other ways in which traders can observe potential trading opportunities is using the MACD histogram. This is a straightforward graphical representation of the difference between the MACD indicator line and the trigger line. It is shown as a series of vertical lines positioned either below or above the zero line, these reflect the relative strength of the price move on the close of every bar. When there is a strong move in price the histogram moves away from the zero line as the signal line and the MACD indicator move apart. At the moment when the two lines crossover the histogram will therefore read as zero. The stronger the subsequent move, the larger the MACD histogram appears and when the move is weaker the histogram will be smaller.
The MACD histogram provides traders with an excellent tool to preempt changes in momentum. These changes very often precede a change in price and the histogram can be used by technical analysts to detect when a stock, currency or commodity may be losing or gaining momentum prior to the change in price. In terms of gaining momentum, a rising MACD histogram can reaffirm that the current price direction is strong and support the reasoning for a trade in that direction. More importantly, the MACD histogram can show us when price is weakening and momentum is waning. It does this in two ways; first, by simply reaching its maximum ´momentum peak´ where it literally cannot move much further away from the zero line. This situation tells traders that a price correction may be due despite the fact that it is an unbounded indicator, the moving averages have become overstretched and the current momentum has reached its peak. The second representation of weakening momentum is when the indicator shows a clear divergence between current price and the level of the MACD histogram. If price is continuing to a lower level but the MACD histogram is refusing to respond by forming a higher low and moving closer to the zero line this is a clear signal that momentum is slowing and a possible change of direction may be due.