Technical Analysis: Components and application of MACD Indicator

MACD is an acronym for moving average convergence divergence. Created by Gerald Appel in the late 1970s, the indicator is one of the most popular tool in use today. Market participants use MACD for determining trend direction, momentum and potential reversals.

Default settings of MACD indicator: The values of 12, 26 and 9 are typical setting used with the MACD indicator; however traders can adjust the values according to their trading style and requirements.

Components of MACD indicator:
The two lines in MACD indicator are the MACD Line and the Signal Line. The other is the MACD histogram that is produced from the moving average lines.
The MACD Line: The MACD line (Fast Line) is calculated as the difference between the 12-period EMA (Exponential Moving Average) and the 26-period EMA. For example, if the 12-period EMA stands at 100 and the 26-period EMA stands at 90, then the MACD line value would be at 10. (100-90)= 10.
The Signal line (Slow line) is the 9-period EMA of the MACD line.
The MACD histogram: MACD histogram is positive when MACD line is above the signal line and negative when it is below. Formula MACD Line- Signal Line.

How can a trader interpret the signals from MACD indicator?
Signal line crossover: Under this approach, a bullish signal is generated when the MACD line turns up and crosses above the Signal line. While a bearish signal is generated when the MACD line turns down and crosses below the signal line.
MACD Divergences: A bearish divergence is when the price is making new highs, but the MACD isn’t. A bullish divergence is when the price is making new lows, but the MACD isn’t. A key point to note while trading divergences is that until divergence is confirmed by an actual reversal in price, don’t trade merely on divergence. A stock can continue to rise (decline) for a long time even while bearish (bullish) divergence is occurring.

Some of the key observations of the MACD Indicator by Anthony Beardsell, all –star trade and author of the book Mind Management & Mindfulness:
When the MACD line is above zero and pointing up the trend is positive and bulls have control. It means that the 12-period EMA is above the 26-period EMA, this point to rising prices and rising momentum. When the MACD line is below zero and pointing down it indicates falling prices and falling momentum.
When the MACD line is above the signal line and the gap is spreading it indicates that momentum is strongly in favour of the bulls. The histogram will be growing at this stage and showing green bars.
When the MACD line is below the signal line and the gap is widening is indicates that momentum is strongly in favour of the bears. The histogram will be growing at this stage and showing red bars.
When the MACD line is above zero and pointing down it indicates that the trend is probably positive, but momentum is bearish (price going down or upward momentum is slowing).
When the MACD line is below zero and pointing up it indicates that the trend is probably negative, but momentum is bullish (price going up or downward momentum is slowing).

Conclusion: The MACD indicator is a useful tool for a trader to have it in their arsenal, but one should understand that it is prone to whipsaws.