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How to Calculate And Interpret the Moving Average Convergence Divergence

24 Nov 2023

Introduction

The Moving Average Convergence Divergence (MACD) is a popular technical indicator used in financial markets, especially in technical analysis. It is primarily employed to identify potential trends, reversals, and momentum in the price of an asset. 


How to Calculate the Moving Average Convergence Divergence? 

Calculating the MACD involves the following six steps. 

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Step 1: Choose the Period:

Typically, the MACD is calculated using two specific periods: a shorter one (often 12 periods) and a longer one (often 26 periods). These periods can represent days, weeks, or another timeframe depending on your trading or analysis preferences.

Step 2: Calculate the Shorter Exponential Moving Average (EMA12):

  • Gather the closing prices of the asset for the specified shorter period (e.g., 12 days).
  • Calculate the simple moving average (SMA) for these closing prices over the specified period.
  • Apply the exponential smoothing formula to calculate the EMA for the current period:

EMA today = (Closing Price today * Smoothing Factor) + (EMA yesterday * (1 - Smoothing Factor))

  • The smoothing factor for a 12-period EMA is typically 2 / (12 + 1) = 0.1538.

Step 3: Calculate the Longer Exponential Moving Average (EMA26):

Repeat the process as you did for the shorter EMA, but this time use the closing prices for the longer period (e.g., 26 days).

Step 4: Calculate the MACD Line:

Subtract the EMA26 value from the EMA12 value to calculate the MACD line.

MACD Line = EMA12 - EMA26

Step 5: Calculate the Signal Line:

Calculate a 9-period EMA of the MACD line to generate the signal line.

Signal Line = 9-period EMA of MACD Line

Step 6: Calculate the MACD Histogram:

Subtract the signal line value from the MACD line to calculate the MACD histogram.

MACD Histogram = MACD Line - Signal Line

How to Interpret the Moving Average Convergence Divergence? 

  • When the MACD line goes above the signal line, it brings about a bullish signal, representing a potential uptrend.
  • Conversely, when the MACD line goes below the signal line, it makes a bearish signal, proposing a potential downtrend.
  • When the MACD line crosses above the signal line, it reinforces a bullish signal.
  • When the MACD line crosses below the signal line, it reinforces a bearish signal.

What are the Limitations of the Moving Average Convergence Divergence? 

  • MACD is a lagging indicator, meaning it relies on past price data to generate signals.
  • MACD can generate false signals in choppy or sideways markets, leading to losses.
  • MACD can be sensitive to short-term market noise and fluctuations.
  • Traders may be tempted to adjust MACD settings to fit historical data, resulting in optimization bias.

Conclusion

The MACD is a versatile tool that can be applied to various timeframes and financial instruments by all types of investors.

 

Related Articles:  Everything You Need to Know About Iron Butterfly Options Strategy | Understanding the Potential of 30-Day Moving Averages in Financial Analysis

 

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