Understanding the Moving Average Convergence Divergence

This article covers the moving average convergence divergence indicator, commonly referred to as the MACD indicator (pronounced "mak dee"). It is a very useful indicator and one of the most followed indicators for technical analysis in trading markets.

What Is MACD comprised Of?

MACD has a lot of different versions. The most common MACD indicator is simply two moving averages that track the market. One moving average is short term, while the other moving average is of a longer duration. This creates a dynamic where there is one line that whipsaws with the market, which is the short-term moving average. The other line is less sensitive to the changes in the market. That is the longer-term moving average. Most typically, the MACD will use the 20-day and 40-day moving averages.

Keep in mind that one can use different number parameters for the moving average days. Also, there are triple moving average indicators in technical analysis that use the same idea, but instead of two moving averages, the triple MACD uses three moving averages.

What Does Convergence Divergence Mean?

Two major events to look for with the MACD are the convergence and the divergence of the two moving average lines. Divergence is a momentum-building event that indicates that increased rates of return are imminent. Convergence is the opposite effect, essentially a slowing down of the rates of return in the near term.

If the moving averages are pointing up, that means we can expect an upswing in prices. The opposite is true for a downswing in prices.

What about the Zero Line?

We have a major bullish indication when the moving averages are above the zero line. This essentially means we are more than just expecting an upswing. We see a seismic shift for a new bull market so long as the lines move and stay above the zero line. If you back-test a strategy that proceeds to buy a market anytime the MACD lines move above the zero line, you will find very good results. Your next step would be to rule when to take profits or sell losses short.

The greatest bullish indication is, of course, when the MACD lines are not only passing above the zero line but are diverging paths. These are two different events, because there could be a passing through the zero line but no diverging of the two averages. Remember, divergence is the momentum-building event where the shorter (faster) moving average is increasing faster than the longer (slower) moving average. This can be analogous to increasing the velocity in a car or plane.

Once you begin to understand the basics of MACD dynamics, you can start to build a strategy that uses MACD indicators in your trading system. It can be used with different indicators or by itself. Surprisingly, given the right types of markets, like foreign exchange and commodities, MACD indicators are very useful by themselves in building successful trading strategies or systems.