January 26, 2024

Moving Average Convergence Divergence

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The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator widely used in technical analysis of financial markets. It reveals changes in the strength, direction, momentum, and duration of a trend in a stock’s price.

Definition

The MACD is calculated by subtracting the long-term Exponential Moving Average (EMA) from the short-term EMA, which results in the MACD line. A signal line, which is the EMA of the MACD line, is then plotted alongside to indicate buy or sell signals.

Calculation

The MACD involves the following components:

1. MACD Line: It is the difference between the 12-day EMA and the 26-day EMA. [See calculation of EMA here]

MACD Line = 12-day EMA − 26-day EMA

2. Signal Line: This is typically a 9-day EMA of the MACD Line.

Signal Line = 9-day EMA of MACD Line

3. MACD Histogram: It represents the difference between the MACD Line and the Signal Line. A histogram above zero indicates a bullish trend, while below zero indicates a bearish trend.

MACD Histogram = MACD Line − Signal Line

Example

Let’s consider a hypothetical stock. Assume you have already calculated the EMAs:

  • 12-day EMA = $50
  • 26-day EMA = $48
  • 9-day EMA of the MACD Line (from previous days) = $1.5

1. Calculate the MACD Line:

MACD Line = 50 − 48 = 2

2. Calculate the Signal Line:

If the previous Signal Line value was $1.5, assume a slight increase (as an example):

Signal Line = Assumed to be = 1.6

3. Calculate the MACD Histogram:

MACD Histogram = 2 − 1.6 = 0.4

So, the MACD Line is 2, the Signal Line is 1.6, and the MACD Histogram is 0.4.

Usage in Financial Analysis

  • Trend Identification: When the MACD Line crosses above the Signal Line, it’s considered bullish; when it crosses below, it’s considered bearish.
  • Divergences: If the MACD is diverging from the price action (e.g., the price is making a new high but the MACD is not), it could indicate a reversal.
  • Overbought/Oversold Conditions: The higher or lower the MACD Histogram, the more overbought or oversold the market may be.

As with other technical indicators, it’s important to use the MACD in conjunction with other analysis tools to confirm trends and signals. It’s particularly effective in trending markets but can provide false signals in ranging or volatile markets.

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