Level: Beginner
Moving Average Convergence Divergence, or MACD is a tool that can identify entry and exit points in a particular trade. It does this by determining when a trend begins and when it ends. Understanding this concept does, however, require a basic knowledge of Exponential Moving Averages (EMA). If you are unacquainted with EMAs, just give Michael’s minute blog on moving averages a good read. It should teach this concept sufficiently. That being said, the most commonly used MACD is calculated as follows:
MACD = 12 day EMA – 26 day EMA
Analysts then usually take a 9 day moving average of the MACD called the signal line. This signal line is then usually plotted alongside the MACD chart. This graph reveals trends that investors use to trade. When the MACD crosses above the signal line, traders take this as a bullish sign and they tend to purchase shares in the stock. When the MACD falls below the signal line, traders take this as a bearish sign and they usually sell their shares in the stock.
Traders also look for other trends in this graph. When the security’s price veers away from the MACD, it is called a divergence. Investors see this divergence as an end in the current trend. However, this method can often generate false trading signals.
Normally when the MACD diverges dramatically higher from the signal line, it suggests that the stock may be overbought. Normally, the market will correct itself and bring the price back down again. However, the market may not “correct itself” if the company’s fundamentals have made a drastic change.
Enjoy Your Trading!