How to Interpret the MACD on a Trading Chart

The Moving Average Convergence Divergence (MACD)
technical indicator features an assortment of applications. Developed by Gerald
Appel, the MACD indicator has been used extensively for more than 40 years and
remains a household name among technical analysts.

The MACD is a customisable indicator primarily used
to recognise momentum shifts, identify trend and trend reversal signals, and distinguish
between overbought and oversold markets. It can also be employed across a range
of asset classes and is utilised by short-term scalpers and day traders, as
well as longer-term swing traders and position
traders.

What is the MACD Indicator?

The MACD indicator consists of several
components, including the MACD line, the Signal Line, and the Histogram.

Unlike the Stochastic
Oscillator or the Relative
Strength Index (RSI), the MACD is an unbounded
indicator. As per Figure 1, the MACD indicator is situated in a lower panel,
separated from the price chart (in this case, a candlestick
chart). However, some charting platforms permit the indicator to be plotted
above.

The MACD Line (marked blue) is calculated by subtracting
the 26-period Exponential Moving Average (EMA) from the 12-period
EMA; it is the difference between these two EMAs. The Signal Line, marked red,
is the 9-period EMA of the MACD Line. The MACD Line is the faster moving
average, while the Signal Line is the slower moving average. Finally, the MACD
Histogram – the vertical bars fluctuating above and below the zero line – is the
difference between the MACD and Signal Lines. This 26, 12, 9 format
tends to be the default for the MACD indicator.

Interpreting MACD Signals

MACD Crossover:

One of the most popular ways of using the MACD
involves the MACD Line and the Signal Line: bullish and bearish crossovers.

Once the MACD Line crosses above (or below) the
Signal Line, this indicates an uptrend (downtrend) could be beginning. Traders
can buy and sell based on these crossovers; however, it is vital to note that
many traders seldom rely on an isolated signal to generate trading
decisions. They generally opt for a convergence of signals.

As illustrated in Figure 2, the MACD Line
crossed above the Signal Line in October 2023, marking the beginning of a
strong upmove. Given that the MACD Histogram is computed by calculating the
difference between the MACD and Signal Lines, it should not be surprising that
the MACD Histogram registered a zero value at the crossover (more on this later).

MACD Overbought and Oversold Signals

Despite lacking defined boundaries, the MACD
can identify overbought and oversold conditions. Experienced traders assess
historical extremes to identify these areas. This is similar to locating support
and resistance areas on a price chart and
extending them to the right, but instead, this is done on the indicator.

In Figure 3, previous extremes were marked
using the areas in red (circles) and extended to the right. Aside from an active
push higher in April 2024, the highlighted borders have served well as
overbought and oversold areas in the past few years. As a result, when price
tests these extreme areas, buyers (sellers) could be overheated, and a
correction (pullback) in price could materialise.

MACD Divergence

The MACD Divergence signal is a valuable part
of the MACD indicator. Like other momentum oscillators, a divergence signal arises
when the indicator and price diverge: one trends higher while the other trends
lower.

For the MACD indicator, the focus is on the
MACD Line. Figure 4 demonstrates a downward trending market, following price
forming a top in March 2022 (red circle). Momentum began slowing in the second
half of 2022, portrayed through the MACD Line forming a higher low (as you
would find in a regular uptrend on a price chart), while price movement
established a lower low (as you would find in a standard downtrend). This
divergence shows that momentum to the downside is slowing, and a trend reversal
may unfold. This is called regular positive divergence, when the indicator
leads price
action. An example of regular bearish divergence
was also seen in 2023, shown through price forming higher highs and the MACD
Line failing to follow suit.

MACD Histogram

As already emphasised, the MACD Histogram
represents the difference between the MACD Line and the Signal Line.
Consequently, traders use the MACD Histogram to estimate MACD crossovers
through divergences.

In strong moving markets, the MACD Line and
Signal Line diverge. In a strong uptrend, the MACD Line will rise above the
Signal Line, for example. However, when upside momentum slows, the MACD Line
and Signal Line converge. The MACD Histogram provides an early warning signal
of convergence and a possible crossover, as shown in Figure 5. Between February
and March 2023, the MACD Line and the Signal Line were diverging and moving
lower. At the same time, though, the MACD Histogram was rising, suggesting that
the MACD Line and Signal Line may converge and eventually pencil in a bullish
crossover.

MACD FAQs

1. What
is the MACD?

The MACD, or Moving Average Convergence
Divergence, is a well-known technical
indicator that helps traders assess trend strength
and identify possible turning points in price.

2. How
do we interpret MACD signals?

As explained in the article, MACD signals take
the form of crossovers, overbought and oversold indications, and divergences to
ultimately assess a market’s trend strength.

3. Do
traders prefer one signal over another?

Most traders underline the importance of
divergence signals at extremes. This means finding divergence signals at
overbought and oversold areas.

However, it must be noted that the MACD signals
are just that: signals. They do not guarantee that price will do as
suggested. This is why back testing trading strategies is vitally important.

This article was written by FL Contributors at www.forexlive.com.