The moving average convergence divergence,
or MACD, is a trading indicator, which can help measure a stock’s momentum and identify
potential entries and exits. The MACD is a lower indicator, meaning it
usually appears as a separate chart below a stock chart. It has multiple components, so we’ll break
them down one at a time before showing how they can be used together to determine buy
and sell signals. First is the MACD line itself. It is an oscillator, meaning it centers on
a zero line that it moves above and below. Generally, when the MACD line moves above
zero, this means the stock is gaining upward momentum. When it moves below the zero line, it means
the stock is gaining downward momentum. Seeing how the MACD line is calculated can
help you understand why. The MACD line represents the distance between
a shorter moving average and a longer moving average. The shorter moving average is typically the
12-day exponential moving average, or EMA, and represents the stock’s more recent price
movement. The longer moving average, typically the 26-day
exponential moving average, represents the stock’s longer-term price movement. The shorter moving average moves more quickly. Sometimes, it moves closer or converges with
the longer moving average. Sometimes, it moves further or diverges. That convergence and divergence is what the
MACD line measures and where it gets its name. The idea is that by comparing a stock’s
more recent price movement to its longer-term price movement, you can get a better view
of the price trend. For example, when the MACD line crosses above
the zero line, the 12-day EMA is moving above the 26-day EMA, meaning recent prices are
getting stronger, which could be a bullish signal. On the other hand, when the MACD line crosses
below the zero line, the 12-day EMA moves below the 26-day EMA, meaning recent prices
are getting weaker, which could be a bearish signal. These basic centerline crossovers are useful
for helping identify a trend. But many traders use a more precise version
of the indicator to identify potential entry and exit signals. That’s where the second component of the
MACD indicator comes in—the signal line. Typically, investors use the 9-day exponential
moving average of the MACD itself as the signal line. Comparing the MACD to a moving average of
itself can give investors a more precise view of momentum changes and when new trends may
be starting, which could help pinpoint potential buy and sell signals. A crossover occurs when the MACD crosses above
or below the signal line, which can signal that a trend may be reversing. For example, a bullish crossover occurs when
the MACD crosses above the signal line. Some investors may consider this a “buy”
signal. On the flip side, a bearish crossover occurs
when the MACD crosses below the signal line, and some investors may consider this a “sell”
signal. Another common component of the MACD indicator
is the histogram, which is another way investors can identify crossovers. The histogram plots the difference between
the MACD and the signal line as a bar. When the histogram has a value of zero, that
means the MACD and its signal line have the same value. For example, if the MACD is below the signal
line, the histogram plots a negative value. But as the MACD crosses above the signal line,
the histogram displays a crossover and plots a positive value. In other words, when the histogram goes from
negative to positive, it coincides with the MACD crossing above the signal line when the
stock turns bullish. The opposite is also true. When a stock turns bearish, an investor could
use the histogram to anticipate a MACD crossover before it occurs by watching the slope of
the histogram. For example, when the histogram has been rising
and then it starts to fall, it might signal a negative crossover could be on the horizon. Now that you know how the histogram works,
let’s look at an example of how you can use it. Suppose an investor sees the histogram plotting
upward. She could interpret this as an early entry
signal and decide to buy the stock. Once in the trade, she notices the histogram
is plotting downward way before the signal line crosses over. At this point, she could decide to exit the
position. Using the histogram is another example of
how the MACD can help an investor identify potential buy and sell signals. However, using the MACD indicator alone doesn’t
always give a complete picture. Investors may experience whipsaws when using
the MACD. A whipsaw occurs when the MACD gives a signal
in one direction and then quickly gives another signal in the other direction. The MACD can also be late in identifying buy
and sell signals because it relies on exponential moving averages that use historical data. This can cause a lag between the current stock
price and a buy signal in the indicator. Because of these drawbacks, investors often
use other forms of confirmation, like trendlines, divergences, and candlestick charts. While the MACD isn’t a guaranteed indicator
of when to buy or sell stocks, it can be a tool to help you make more informed trading
decisions.