In our articles on SMA (Simple Moving Average) and EMA (Exponential Moving Average), we have seen how useful comparing several Moving Averages can be to detect trends. The Moving Average Convergence Divergence is an indicator built from the difference between two Exponential Moving Averages of different periods. The Moving Average Convergence Divergence (MACD) indicator is a technical analysis tool used to identify potential trend reversals and confirm existing trends. It is composed of two exponential moving averages that are calculated using different parameters. The first line, called the MACD line, is calculated by subtracting a 26-day exponential moving average from a 12-day exponential moving average. The second line, called the signal line, is calculated by taking a 9-day exponential moving average of the MACD line.
The first thing to calculate are the two EMAs. Generally, traders prefer to use a 12-period and and 26-period EMA. You may refer to our article on Exponential Moving Averages if you don't know how to calculate an EMA. The first element of the indicator is then the difference between the shorter and the longer EMA. A Signal line is added, which consists in the 9-period EMA of the MACD.
The MACD gives us three informations. First, the it indicates the direction of the trend. A rising MACD line represents a positive trend - since it means that the short EMA is above the long EMA. A downward line represents a negative trend.
Second, this indicator also gives the strength of the trend. The greater the distance between the two lines, the stronger the trend. Indeed, the greater the distance, the fastest the price is moving away from the two EMAs. And remember that the short EMA follows the price quicker than the long one. This translates into larger candles. The larger the candle, the stronger the trend.
Third, the MACD indicator also gives buy or sell signals. It is generally considered that the MACD line crossing above the Signal line gives a buy signal. When the MACD line crosses below the Signal line, the indicator gives a sell signal.
We can see that the market turns bullish when the MACD gives a buy signal. The MACD line crosses above the Signal line. The trend reversal is signaled way before the the 12-period EMA crosses above the 26-period EMA. The market becomes bearish when the MACD falls below the Signal line.
When used in combination with other technical analysis tools and indicators, the Moving Average Convergence Divergence (MACD) indicator can provide improved market analysis. Here is a list of other indicators that can be used in combination with the MACD indicator:
It's important to note that no single indicator is perfect, and traders should use a combination of indicators to confirm the validity of any potential trading signals. Additionally, it's important to keep in mind that technical analysis is not a sure thing, it's a tool that can be used to help traders make more informed decisions. It's crucial to always have a risk management plan in place and not to rely solely on a single indicator to take any trading decision.