What Is Moving Average Convergence Divergence – MACD?

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Thousands of shares are listed in the share market and each one undergoes distinct price movements throughout the day. How to make sense of such random movements? Thankfully, data scientists over generations have devised tools to interpret these otherwise undecipherable moves. These tools are called indicators. True to its name, they indicate probable market direction basis historical price. There are many indicators capturing varying aspects of stock price movement. On such indicator is MACD.

The moving average convergence divergence indicator or MACD is used by traders to evaluate the market trends over different time intervals. MACD is a pivotal indicator in the trading community serving an important role of identifying buy and sell signals. It helps traders gauge the trend and momentum. MACD indicator works as a momentum oscillator.

In general, MACD calculation is done by subtracting the 26-day exponential moving average (EMA) from the 12-day exponential moving average. A 9-day EMA of the MACD Line is then plotted and this is used as a “signal line” to understand the buy and sell signals. A trader can also use their own settings for MACD.

How MACD Works?

With the abovementioned MACD calculations, we need to make sense of how to interpret them.

The MACD indicator will have a positive value if the 12-day EMA is above the 26-day EMA and vice-versa. A positive MACD value will indicate an increasing upward momentum. This will indicate that they should not go for a short position till the signal indicates so. Whereas a negative MACD value will indicate that the downtrend of the share price may continue, and it will not be an ideal time to go for a long position.

If the MACD value is below the signal line, it indicates a bullish trend is approaching, while if it is above the signal line it is indicative of a bearish trend. If it is constantly hovering around the signal line, traders usually avoid taking a trade as it can be volatile in such situations.

How is MACD Calculated?

MACD calculation is simple. A 26-day exponential moving average (EMA) is subtracted from the 12-day exponential moving average. This identifies the relationship between two moving averages of a stock’s price. A 9-day EMA of the MACD Line is then plotted and used as a “signal line” to generate buy and sell signals. These numbers are generally used across the trading community, however, a trader with a different style of trading can replace them with their own setting.

MACD Line : It is calculated as, 12-day EMA - 26-day EMA

Signal Line : It is a 9-day EMA of the MACD Line. This is also known as a trigger line.

MACD Histogram : This is calculated by subtracting the signal line from the MACD line.A positive histogram value indicates that MACD is higher than its 9-day moving average and indicates a recent shift in momentum in the positive direction. While a negative value indicates a recent downward movement in terms of momentum.

Limitations of MACD

MACD is a widely used indicator that helps traders identify buy and sell signals, but it does come with a few limitations. It is more relevant for short-term trading. The standard long-term measurement that is taken in 26-day; this is relatively short in the context of stock market.

Another limitation is that MACD does not work well in a consolidating market. MACD sometimes signal a reversal, however, that fails to materialize.

The traditional MACD settings may not work in all scenarios. A trader must be familiar with various kinds of settings that will help them identify momentum and price trends better.

Like a few other technical indicators, MACD may give late signals as this is a trend-following indicator. This essentially means the signal is triggered after the trade has happened and can be a lost opportunity for a trader. It is a trend indicator and usually the signal is triggered when the trend has already happened.

It may not be an ideal choice to analyse upcoming trends. The idea of delayed and false signals is prevalent across most of the technical indicators used to analyse. So MACD may not be an exception in this case, however, it faces similar limitations.

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