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On-screen disclosure: Schwab does not recommend the use of technical analysis as a sole means of investment research.
Narrator: The moving average convergence divergence, or MACD, is a trading indicator, which can help measure a stock's momentum and identify potential entries and exits.
The MACD is a lower indicator, meaning it usually appears as a separate chart below a stock chart. It has multiple components, so we'll break them down one at a time before showing how they can be used together to determine buy and sell signals.
First is the MACD line itself. It is an oscillator, meaning it centers on a zero line that it moves above and below. Generally, when the MACD line moves above zero, this means the stock is gaining upward momentum. When it moves below the zero line, it means the stock is gaining downward momentum.
Seeing how the MACD line is calculated can help you understand why.
The MACD line represents the distance between a shorter moving average and a longer moving average. The shorter moving average is typically the 12-day exponential moving average, or EMA, and represents the stock's more recent price movement. The longer moving average, typically the 26-day exponential moving average, represents the stock's longer-term price movement.
The shorter moving average moves more quickly. Sometimes, it moves closer or converges with the longer moving average. Sometimes, it moves further or diverges. That convergence and divergence is what the MACD line measures and where it gets its name. The idea is that by comparing a stock's more recent price movement to its longer-term price movement, you can get a better view of the price trend.
For example, when the MACD line crosses above the zero line, the 12-day EMA is moving above the 26-day EMA, meaning recent prices are getting stronger, which could be a bullish signal. On the other hand, when the MACD line crosses below the zero line, the 12-day EMA moves below the 26-day EMA, meaning recent prices are getting weaker, which could be a bearish signal.
These basic centerline crossovers are useful for helping identify a trend. But many traders use a more precise version of the indicator to identify potential entry and exit signals. That's where the second component of the MACD indicator comes in—the signal line.
Typically, investors use the 9-day exponential moving average of the MACD itself as the signal line.
Comparing the MACD to a moving average of itself can give investors a more precise view of momentum changes and when new trends may be starting, which could help pinpoint potential buy and sell signals. A crossover occurs when the MACD crosses above or below the signal line, which can signal that a trend may be reversing.
For example, a bullish crossover occurs when the MACD crosses above the signal line. Some investors may consider this a "buy" signal.
On the flip side, a bearish crossover occurs when the MACD crosses below the signal line, and some investors may consider this a "sell" signal.
Another common component of the MACD indicator is the histogram, which is another way investors can identify crossovers. The histogram plots the difference between the MACD and the signal line as a bar. When the histogram has a value of zero, that means the MACD and its signal line have the same value.
For example, if the MACD is below the signal line, the histogram plots a negative value. But as the MACD crosses above the signal line, the histogram displays a crossover and plots a positive value.
In other words, when the histogram goes from negative to positive, it coincides with the MACD crossing above the signal line when the stock turns bullish. The opposite is also true. When a stock turns bearish, an investor could use the histogram to anticipate a MACD crossover before it occurs by watching the slope of the histogram. For example, when the histogram has been rising and then it starts to fall, it might signal a negative crossover could be on the horizon.
Now that you know how the histogram works, let's look at an example of how you can use it.
On-screen disclosure: The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern, or investment strategy.
Narrator: Suppose an investor sees the histogram plotting upward. She could interpret this as an early entry signal and decide to buy the stock.
Once in the trade, she notices the histogram is plotting downward way before the signal line crosses over.
At this point, she could decide to exit the position.
Using the histogram is another example of how the MACD can help an investor identify potential buy and sell signals.
However, using the MACD indicator alone doesn't always give a complete picture.
Investors may experience whipsaws when using the MACD. A whipsaw occurs when the MACD gives a signal in one direction and then quickly gives another signal in the other direction.
The MACD can also be late in identifying buy and sell signals because it relies on exponential moving averages that use historical data. This can cause a lag between the current stock price and a buy signal in the indicator.
Because of these drawbacks, investors often use other forms of confirmation, like trendlines, divergences, and candlestick charts.
While the MACD isn't a guaranteed indicator of when to buy or sell stocks, it can be a tool to help you make more informed trading decisions.
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