MACD is an acronym for Moving Average Convergence Divergence. This indicator is used to identify moving averages that are indicating a new trend, whether it's bullish or bearish. Every trader’s top priority is being able to find a trend because that is where the most money is made.
Question is: How did they come about the name Moving Average Convergence Divergence?
Let’s start by explaining the concept behind this indicator.
When you load up a MACD indicator on your trading chart, you will usually see three numbers that are used for its settings.
• The first is the number of periods that are used to calculate the faster-moving average.
• The second is the number of periods that are used in the slower moving average.
• And the third is the number of bars that are used to calculate the moving average of the difference between the faster and slower moving averages.
For example, if you open a MACD on your charting software, the parameters you would see are "12, 26, 9". This is how you would interpret those numbers:
• The 12 represents the previous 12 bars of the faster-moving average.
• The 26 represents the previous 26 bars of the slower moving average.
• The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram.
The two lines that are drawn are NOT moving averages of the price. Rather, they are the moving averages of the DIFFERENCE between two moving averages.
In the example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages.
The slower moving average on the other hand plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average.
This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If you look at the chart, you can see that, as the two moving averages separate, the histogram gets bigger.
This is called divergence because the faster moving average is "diverging" or moving away from the slower moving average.
As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is "converging" or getting closer to the slower moving average.
Because there are two moving averages with different "speeds", the faster one will obviously be quicker to react to price movement than the slower one.
When a new trend occurs, the fast line will react first and eventually cross the slower line. When this "crossover" occurs, and the fast line starts to "diverge" or move away from the slower line, it often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears.
This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is a good indication of a strong trend.
Take a look at this chart below.
In the chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend would eventually reverse.
From then on, the price began shooting up as it started a new uptrend. Assuming you bought this after the crossover, you would have made a good number of profits.
There is one drawback to MACD though. Since all moving average lag behind price, because they calculate the average of historical prices, the same lagging is also expected of the MACD indicator also.
Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, the lagging is inevitable. However, MACD is still one of the most favored tools by many traders.
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