The moving average convergence divergence (MACD) is an indicator that shows the momentum in equity markets. It’s especially popular with traders, who use it to help them rapidly identify short-term momentum swings in a stock.
A moving average can help investors see past the noise of daily market movements to find securities trending up or down. The MACD offers another way to focus on such stocks, by showing the relationship between two moving averages.
Understanding the Moving Average
The moving average convergence divergence may sound complex, so it makes sense to start with the first part – the moving average (MA), also called the exponential moving average, or EMA. This is a very common metric with stocks, used to make sense of ever-fluctuating price data by replacing it with a regularly updated average price. This moving average can give investors a clearer idea of where a stock is trading than one that’s updated second by second.
Because the moving average reflects past prices, it is a lagging indicator. But how much the past prices factor in depends on the person setting the average. Most commonly, investors look at moving averages of 15, 20, 30, 50, 100, and 200 days, with the 50- and 200-day averages being the most widely used.
A moving average with a shorter time span will be more sensitive to price changes, while moving averages with longer time spans will fluctuate less dramatically. Generally, active traders with strategy focused on market timing favor shorter-duration moving averages.
To perform the MACD calculation, traders take the 26-day moving average of a stock and subtract it from that stock’s 12-day moving average. This calculation offers a quick temperature-check of a stock’s momentum.
While the 12-day and 26-day time spans are standard for the MACD, investors can also create their own custom MACD measurements with time spans that better fit their own particular trading tactics and investment strategies.
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How to Read MACD
If a stock’s MACD is positive, that means its short-term average is higher than its long-term average, which could be a bullish indicator that stock is on an upswing. A higher MACD indicates more pronounced momentum in that upswing. On the other hand, a negative MACD indicates that a stock is trending downward.
If the positive or negative difference between the shorter-term and longer-term moving averages expands, that’s considered the MACD divergence, or the D in MACD. If they get closer, that’s considered a convergence, the C in MACD.
When the two moving averages converge, they meet at a place between the positive and negative MACD, called the zero line, or the centerline. For many traders, this MACD crossover is the sign they wait for to jump into a stock, which after losing value, is suddenly gaining value. Conversely, a stock crossing the zero line of the MACD is often taken to mean that the good times are over, leading many traders to sell at that point.
The MACD is a vital concept in technical analysis, a popular approach investors use to try to forecast the ways a stock might perform based on its current data and past movements. It involves a wide range of data and trend indicators, such as a stock’s price and trading volume, to locate opportunities and risks.
Technical analysis does not look at underlying companies, their industries, or any macroeconomic trends that might drive their success or failure. Rather, it solely analyzes the stock’s performance to find patterns and trends.
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The MACD as a Trading Indicator
For traders, a rising MACD is a sign that a stock is being bid up. The MACD shows how quickly that’s happening.
As the short-term average rises above the longer-term average, and the two figures diverge more widely, the MACD expresses this in a simple number. When a stock is sinking, investors also want to know how fast it’s falling, as well as whether its decline is speeding up or slowing down, which they can find quickly by looking at the divergence.
A convergence is also a key indicator for many traders. As the long-term and short-term moving averages get closer to one another, it can be a sign that a given stock is either overbought or oversold for the moment. If they hold the stock, it may be time to sell the stock. But if they like the stock, and are waiting for a bargain-basement price at which to buy it, then the convergence of the two averages on the zero line may mean it’s time to start buying.
By using the MACD, traders can also compare a stock to competitors in its sector, and to the broader market, to decide whether its current price reflects its value and whether they should buy, sell, or short a stock. Because the MACD is priced out in dollars, many traders will use the percentage price oscillator, or PPO. It uses the same calculation as the MACD, but delivers its results in the form of a percentage difference between the shorter- and longer-term moving averages. As such, it allows for quicker, cleaner comparisons.
💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
The Pros and Cons of the MACD
The MACD indicator has benefits for traders. It’s a convenient gauge of a stock’s momentum for an active, short-term trader. But it can also help a long-term investor who’s looking for the right moment to buy or sell a stock. Once an investor understands the MACD, it’s an easily interpreted data point to incorporate into their trading strategy.
But the MACD does have its drawbacks and does not account for certain types of investment risk. Because the MACD is a lagging indicator, it can lead to a trader staying too long in a position that’s since begun to swoon. Or, alternately, it can indicate a turnaround that’s already run the bulk of its course.
This is especially dangerous in volatile markets, when stocks can “whipsaw.” This term – named for the push-and-pull of the saw when it’s used to chop down a tree – describes the phenomenon of a stock whose price is moving in one direction, and suddenly goes sharply in the opposite direction. Whether that whipsaw movement is up or down, it can prove highly disruptive for a trader who relies too heavily on the MACD.
The Takeaway
The MACD can be a helpful metric for traders to understand and to use, in conjunction with other tools to help formulate their investing strategy.
The MACD indicator has benefits for traders. It’s a convenient gauge of a stock’s momentum for active traders. But it can also help long-term investors, too, determine when to buy and sell. It’s also a lagging indicator, which can make it tricky to use for inexperienced traders. As always, it’s best to consult with a financial professional if you’re feeling like you’re in over your head.
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