MACD indicator, signals and limitations
I have written different articles about technical analysis. In an earlier post, I discussed the different types of technical analysis that are used and their pros and cons. Besides that, I have discussed the moving average in an article, the use of this technical analysis indicator and the different versions of the moving average. In this article, I will describe the MACD technical analysis method. The MACD is an indicator that uses the moving average.
Moving average convergence/divergence (MACD)
When you have read the article in which I discuss the moving average, you will have a good basis to understand the moving average convergence/divergence (MACD) indicator. If you did not read the article and you do not know exactly what the moving average is all about, I advise you to first read this article.
The MACD indicator is a so called trend following indicator. With the moving average, a trend can be found, with the MACD, the strength of the trend and the possible turning points can be determined. The MACD can de used to recognize the top and bottomlines of trends and with this knowledge, you can reduce the risk of your investments.
The MACD is the difference between a shorter and longer term moving average. By deducting the longer term moving average from the shorter term moving average, you get the MACD value. The used longer term moving average is the 26-days moving average. The shorter term moving average that is used to calculate the MACD, is the 13-days moving average. The MACD line is the line that can drawed through the MACD values. This MACD line is the first MACD indicator.
Part two of the MACD indicator is the MACD signalline. The MACD signalline is the 9-days moving average of the MACD, which can be calculated using the MACD values of the last nine days. To calculate the MACD signalline, most of the time the time-dependent moving average calculation is used. At the time dependent moving average, the earliest (oldest) values counts the least. However, you can also use the simple (regular) calculation of the moving average formulae.
Both the MACD and the MACD signalline will be positioned below the price level of the share, because the MACD is the difference between the longer term moving average and the shorter term moving average and the MACD signalline is based on the MACD. The next question should be: 'How can I use the MACD exactly?'.
Which signals are given by the MACD?
The MACD indicator gives two different types of signals, namely the strength of the trend and the turning points of the trend. The first signal that the MACD indicator gives, is whether the trend is rising of falling. When the MACD rises, the trend is bullish. At the moment the MACD indicator stops rising or the rise is leveling of, the strength of the trend declines and the possibility of a change of the trend increases.
The second signal that the MACD indicator gives, is when the MACD signalline crosses the MACD. When the MACD signalline crosses the line and gets above the MACD, a sell-signal is given. When the MACD signalline crosses the MACD and ends up below the MACD, a buy-signal is sent.
The MACD is a useful technical analysis indicator, because it gives different signals. But, like other technical analysis methods, the MACD also has its downside. First of all, the MACD is a short term indicator. The longest measurement method which is taken into account is the longer term moving average of 26 days.
The second downside of the MACD is the moment at which the MACD indicator gives its signals. As written, the MACD is a trend following indicator. This means that the signals will occur when the trend has already came into existence. Other methods may be more useful to recognize an upcoming trend.
Besides the above cons, I have two general remarks about using technical analysis methods. First of all, not all shares will be trending at the same time. Even worse, at any given moment, most of the shares will not show any trend. And the shares that are trending, may not be in a strong enough trend or in the wrong trend to use this trend. That is why you will have to follow a lot of shares to use technical analysis so you will make the right decisions. This applies to all technical analysis methods, also to the MACD indicator.
The second general remark is that each technical analysis methods can give false signals. So be careful when you use these methods!