There are different market price momentum indicators. One of the key ones is known as Moving Average Convergence Divergence — MACD. This indicator is widely used by day traders and analysts. The indicator makes use of the divergence between two EMAs to measure the strength of the fluctuation in the stock prices.
What is Moving Average Convergence Divergence — MACD?
Moving average convergence divergence (MACD) is an indicator which functions as a momentum oscillator. It follows the trend taken by the market by showing the relation between moving averages (MA) of prices. Even though MACD acts as an oscillator, it is generally not utilised for the identification of oversold and overbought conditions. On the chart, it appears as two lines which demonstrate oscillation beyond their boundaries. The crossover between the two lines provides trading signals in the similar way as the 2 moving average system.
Calculation of Moving Average Convergence Divergence. — MACD
For calculating the approximatedMoving Average Convergence Divergence (MACD):
Subtract the value of 26 day EMA (Exponential Moving Average) from the 12 day EMA. The short EMA shows constant divergence away and constant convergence toward the long EMA. This leads to the oscillation of the MACD in the vicinity of the zero-level. A nine-period EMA of MACD, known as the ‘signal line’ can be then plotted above the MACD. This zero line functions as a trigger for selling and buying signals. The Zero line offers negative and positive values for MACD calculation. When there is a greater separation between the 26-day EMA and the 12-day EMA, it reflects an increased momentum of the market, up as well as down.
Note: The above method is the default way for calculating Moving Average Convergence Divergence.Traders have an option of adjusting the parameters as per their own criteria.
What is EMA?
Fully called exponential moving average, EMA is the kind of a moving average which attributes more significance and weightage to the most recent and latest data points. Another way of referring to the exponential moving average (EMA) is to call it exponentially weighted moving average (EWMA). Compared to a simple moving average that places the same weight on all the observations of a particular period, the EWMA show greater reaction to the latest price changes.
As understood from any trading signal chart, the emphasis is on a bearish signal when the MACD shows a drop below the signal line. Such a bearish signal is an indication of increased selling opportunities. On the contrary, when the Moving Average Convergence Divergence shows a rise above than the signal line, the emphasis is on a bullish signal. Such a bullish signal suggests that the asset price may show an upward momentum.
When the price of a security demonstrates a divergence from the MACD, it is a signal that the current trend is ending. For instance,traders predict the end of a rally when a stock price trend goes up and the MACD goes down. Similarly, they predict the bullish reversal to occur in the near-term, when the stock price falls and the MACD rises. In such a way, traders make use of the divergence in association with different technical indicators for finding appropriate opportunities.
MACD showing a dramatic rise means the short-term moving average pulling away from the longer moving average. This provides a signal regarding the overbuying of security and points towards their return to their normal levels.Traders often integrate this analysis with other technical indicators like the Relative Strength Index (RSI). This combination helps them in the verification of oversold and overbought conditions in the market.
In addition, traders also look out for a move below or above the zero line. Such an arrangement provides a signal regarding the position of the long-term average relative to the short-term average, indicating zn upward momentum. The opposite happens when the MACD falls below the zero line. In most market charts, the zero line functions as an area of resistance and support for the indicator.
Difference between Moving Average Convergence Divergence and Relative Strength Index (RSI)
The primary difference between the Moving Average Convergence Divergence and Relative Strength Index lies in the traits they measure.
As described above, the MACD helps to measure the strength of the movement in stock price. It happens with the measurement of the divergence between 12-day EMA and the 26-day EMA. When the separation between the 26 day EMA and the 12 day EMA is large, it is an indication of greater market momentum, both up and down.
On the other hand, RSI (Relative Strength Index) provides an indication regarding the market price condition. The RSI shows if the market as compared to the latest price levels is oversold or overbought. The RSI makes calculations of the mean price loss and gains over a specific time period. This time period in the default cases is usually 14 days.
Since both the MACD and the RSI are useful in the measurement of different elements, there are times when contrary indicators occur from both. For instance, when MACD indicates that the market might still rise in its buying momentum, the RSI reading may be above 70. This RSI value would indicate the overextension of the market on the buying side, relative to the recent prices. Both indicators have the ability of signalling a potential trend change by showing a divergence from the market price. Mostly their application should be in combination, for understanding the complete technical condition of the market.
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