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MACD Explained

|Includes: Applied Materials, Inc. (AMAT)
The MACD concept is simple: get early notice before two exponential moving averages (EMAs) cross by measuring the difference between them. New twists developed over the years until the MACD Lines and Histogram grew into the complex technical indicator that is currently in use today. This blog post describes the MACD trading signals in the order of their appearance on the chart, showing you which are the first signals to hint at a potential trend change and which go along with a mature trend.
MACD signals explained in order of appearance
The initial hint of upwards price movement is when the common MACD Histogram gets less negative while still remaining below zero. See Figure 1 - Flag #1. Despite being the first signal, it is the signal most distantly derived from price. It says that the MACD and its Signal line are moving closer together.
 
Next, the MACD line itself moves upwards from below zero as shown by the Figure 1 – Flag #2.  Notice that MACD can be plotted as two different histograms.  In the middle of the chart, MACD histogram is plotted in the usual fashion. In the lower plot, the MACD line is plotted as a histogram which makes it easier to see the change in slope of the MACD.
 
If the price indeed progresses upwards, the MACD line in due time crosses up through its Signal line. This is illustrated by Figure 1 –  Flag #3. The Signal line is typically the 9-bar EMA of the MACD line. The MACD line and Signal line crossing is reflected in the common MACD Histogram as that histogram crossing zero. Often cited as a buy signal, it is still rather removed from price. What a crossing of the MACD lines really means is that the underlying EMAs are now moving towards each other, which must happen if the two EMAs are eventually going to cross each other. 
 
Although any settings can be used, the two EMAs are typically the 12-bar and 26-bar EMAs. At the same time its two EMAs cross, the MACD line crosses zero, as marked by Figure 1 – Flag #4. Whether a trader is looking at MACD or EMAs, this is a very common buy signal. It relates to price because a rising price will cause the EMAs to cross as price moves the shorter (12-bar) EMA up more quickly than the longer (26-bar) EMA.
 
As the price continues to rise, the faster EMA will continue to shoot above the slower EMA, and because it’s the difference between the two, the MACD line will also rise above zero. As the MACD line moves up, it will necessarily move faster than its Signal line.  That pushes the common MACD histogram up higher above zero. Now the up move is fully mature.
 
Sooner or later the MACD Histogram ticks down with a shorter bar (see Figure 1 – Flag #5).  This is often taken as a signal of impending down move. Really, this simply means that the MACD line is not moving away from its Signal line. As the downward move grows, the two EMAs start moving together and the MACD line will move down itself (Figure 1 – Flag #6) in recognition of the slower momentum.
 
Eventually, the MACD line may drop below its Signal line, and that is always the same as the MACD Histogram crossing zero (Figure 1 – Flag #7). As the downward momentum builds, the MACD line drops below its zero line, signaling that the fast EMA has crossed down through the slow EMA (Figure 1 – Flag #8). These are the traditional sell signals from MACD.
 
As the whole process repeats, it’s a common practice to compare the height of the MACD line (or the MACD histogram) with its height on previous price moves. If the price reaches a new low, but the MACD does not confirm a new low, it is said to be a MACD divergence. Similarly, if the MACD histogram does not post a new low in price when price itself makes a new low, that is also a MACD Histogram divergence. Due to the way the indictor is constructed, the MACD histogram will show more divergences than the MACD lines.
 
Extensive backtesting with 7147 stocks over 14 years showed major performance differences between the different MACD signals. To put it bluntly, some MACD signals performed no better than chance while others made gains in the right situations.  To find out how the MACD signals performed, visit The Truth About MACD and watch my free video.
 


Disclosure: No position the example stock AMAT at time of this writing.