Understanding
Stock Options Trading
and Technical Analysis Basics

Moving Average Convergence Divergence Indicator (MACD) Charts

The Moving Average Convergence Divergence charts, or MACD charts for short, are a technical indicator that is derived from the more simple moving average. The MACD charts are oscillating indicators, meaning that they move above and below a centerline or zero point. As with other oscillating and momentum indicators, a very high value indicates that the stock is overbought and will likely drop soon. Conversely, a consistently low value indicates that the stock is oversold and is likely to climb.

The MACD charts are based on 3 exponential moving averages, or EMA. These averages can be of any period, though the most common combination, and the one we will focus on, are the 12-26-9 MACD charts. There are 2 parts to the indicator MACD. We will focus on the first part first, which is based on the stock's 12-Day and 26-Day EMA. As can be seen on the chart below, the 12-Day EMA (in blue) is the faster EMA while the 26-Day (in red) is slower.

The logic behind using a faster and slower EMA is that this can be used to gauge momentum. When the faster (in this case 12-Day) EMA is above the slower 26-Day EMA, the stock is in an uptrend, and vice versa. If the 12-Day EMA is increasing much faster than the 26-Day EMA, the uptrend is becoming stronger and more pronounced. Conversely, when the 12-Day EMA starts slowing down, and the 26-Day begins to near it, the stock movement's momentum is beginning to fade, indicating the end of the uptrend.

MACD chart

The MACD charts use these 2 EMA by taking the difference between them and plotting a new line. In the chart above, this new line is the thick black line in the middle chart. When the 12-Day and 26-Day EMA are at the same value, the MACD line is at zero, such as in early February and mid June. When the 12-Day EMA is higher than the 26-Day EMA, the MACD line will be in positive territory. The further the 12-Day EMA is from the 26-Day EMA, the further the MACD line is from its centerline or zero value.

This line on its own doesn't tell much more than a moving average. It becomes more useful when we take into account its 9-Day EMA. This is the third value when we talk of 12-26-9 MACD charts. Note that the 9-Day EMA is an EMA of the MACD line, not of the stock price. This EMA (the thin blue line alongside the MACD line) acts like a normal EMA and smoothes the MACD line.

The 9-Day EMA acts as a signal line or trigger line for the MACD. When the MACD line crosses above the 9-Day EMA from below, it indicates that the downtrend is over and a new uptrend is forming. Time to consider bullish strategies. This can be seen in early February and mid May. Conversely, when the indicator MACD line drops below its 9-Day EMA, a new downtrend is forming and its time to implement bearish strategies. This can be seen on the chart in early March and early April.

Summary:

Moving Average Convergence Divergence (MACD) charts are oscillating indicators based on exponential moving averages. When the MACD line (the difference between 12-Day and 26-Day EMA) crosses above its 9-Day EMA, the stock becomes bullish. When the MACD line crosses below its 9-Day EMA, its becomes bearish.

So far, we have covered the most simple form of interpreting the MACD charts. We now look at the MACD histogram. The MACD histogram is the blue-and-grey bar chart alongside the MACD line. A larger version has been added beneath it. Just as the MACD line is the difference between the 12-Day and 26-Day EMA, the MACD histogram is basically the difference between the MACD line and its 9-Day EMA.

So when the MACD line crosses above its 9-Day EMA, the MACD histogram will cross above zero. In order words, a bullish signal is obtained when the MACD histogram crosses above zero, and a bearish signal is obtained when it crosses below zero.

Let's look now at the chart below. It is the same chart as the one above, but with different markings. Notice the thick red line drawn on the MACD histogram. The red line shows that the MACD histogram reached a peak in mid February, and reached a subsequent smaller peak in the beginning of March. These progressively lower peaks constitue what is known as a negative divergence.

MACD chart

A negative divergence on the MACD histogram is an indication that the current uptrend might reverse in the near future. This could happen even though the actual stock price seems to be making higher peaks in the chart. Basically, the MACD histogram negative divergence is a warning that the stock might turn down soon, which it did in the chart above. Similarly, the positive divergence on the MACD histogram in January and early February correctly predicted the subsequent uptrend.

However, the positive divergence in March was a false alarm. If we had followed this signal, we would have bought into a downtrend. The primary reason this happened is that during the month of March, the stock was in a trading range, with lower price fluctuations. Note that the MACD line was hovering just above and below zero during this month. Periods of stability and low volitility usually precede a sudden change, the direction of which is usually uncertain. We discuss this phenomenon further when describing Bollinger Bands.

As such, we again remind you that individual indicators such as the Moving Average Convergence Divergence indicator (MACD) charts should not be used on their own, but rather with one or two additional indicators of different types, in order to confirm any signals and prevent false alarms.

Summary:

The MACD histogram is the difference between the MACD line and its 9-Day EMA. A positive divergence in this histogram can be used to predict potential uptrends, while a negative divergence can predict potential downtrends.