What is the MACD indicator?

Posted by professor  at August 22nd, 2013

The MACD indicator is a popular technical trading tool that is used in many stock trading strategies across the investment community and can be used in various different ways depending on the type of market being traded.

MACD stands for Moving Average Convergence and Divergence and was first coined by market technician Gerald Apel in 1979. The indicator measures divergence, follows trends and is also an excellent guide to momentum. It also works well when combined with other indicators, especially those that work in the opposite way to the MACD, for example volatility measures or bands and is one of the most popular trading strategies for stocks and ETFs.

In essence, the MACD works by showing whether a market is converging or diverging away from its trend using two lines and a histogram. An increasing histogram shows divergence while a decreasing one, convergence.

For example, if the market is moving higher but the difference between the two speeds of moving averages is decreasing (converging), the market is making new highs but doing so with less momentum and less conviction. It is therefore becoming stretched and likely to reverse direction.

In just the same way if the market is moving up and the MA’s are diverging, it signals that the market is strong and likely to continue its recent trend. The indicator works in just the same way but in reverse, for a declining trend.

Calculating the MACD

Although the MACD appears complicated at first it is really nothing more than the difference between two moving averages represented on a price chart by two MA lines and a histogram. Even so, most traders will not calculate it themselves since it is easier and more accurate to get a charting package such as TradingExpert Pro to do it for them.

The most common moving averages used when calculating the MACD are the 12 day and 26 moving averages and these are the settings that Gerard Apell had in mind when he developed the system. Even so, it is possible to change these MA’s according to a trader’s preference if need be.

When added to a chart, the MACD will appear with three numbers by its side, typically 12, 26 and 9. As expected 12 and 26 denote the speed of the two moving averages that are used to calculate the divergence. The third figure, 9, measures this divergence between the two averages over the last 9 bars. It is this number that is also represented in the histogram underneath. 

A common mistake

A common mistake when using the MACD is to interpret the two lines as the two moving averages of the price chart. However, this is not actually correct.  Each line actually represents the moving average of the difference between two moving averages and thus clearly shows the divergence.

 Oscillator

To be sure of what exactly the MACD is, we can say that it is an absolute price oscillator (APO), in that it deals with actual prices of moving averages instead of percentages – which would be a percentage price oscillator (PPO). Because of this, values from the MACD, though useful when analyzing one particular stock, should not be compared with values from other stocks, since they will bear no relation to the other. The MACD is thus a filtering mechanism as well as lagging indicator which can be used to great effect in numerous situations as one of many strategies for trading stocks and ETFs.