The MACD Indicator (Moving Average Convergence/Divergence) represents the difference between a longer and shorter (by default: 26 and 12) period Exponential Moving Averages (EMA). To clearly show buy/sell opportunities, a so-called Signal line (by default: 9 period SMA of MACD main line) is plotted on the MACD chart.
The MACD appears to be most effective in wide-swinging (high volatile) trading markets. There are three popular ways to use the Moving Average Convergence/Divergence: crossovers, overbought/oversold conditions, and divergences.
Gerald Appel invented MACD indicator in the 1970’s. Thomas Aspray added a histogram to the indicator in 1986. The histogram was added as a means to anticipate the oscillators crossovers, an indicator of significant moves in the underlying security.
For better understanding assume that we calculate MACD (12, 26, 9).
The main value of the MACD equal to the difference of a 26-period EMA value from a 12-period EMA. A Signal line, red dotted line, calculated by taking SMA from the main MACD value. Than Signal line plotted
MACD = EMA(CLOSE, 12)-EMA(CLOSE, 26)
SIGNAL = SMA(MACD, 9)
EMA — the Exponential Moving Average;
SMA — the Simple Moving Average;
SIGNAL — the signal line of the indicator.
Usage in trading
The MACD indicator depends on three parameters, the time constants of the three EMAs. The notation “MACD(a,b,c)” usually denotes the indicator where the MACD (or MACD Line) series is the difference of EMAs with periods of a and b, and the Signal line, which is the EMA of MACD Line with period c. The most commonly used values are 12, 26, and 9, that is, MACD(12,26,9). Similarly to the most of the classic technical indicators, MACD also finds its period settings from the old days, when mainly the daily charts where available. As the working week used to be 6-days, the period settings of (12, 26, 9) represent 2 weeks, 1 month and one and a half week. Nowadays there are endless variations of settings for the MACD Indicator. Nevertheless, it is always better to stick to the period settings which are used by the majority.
Signal line crossover
A Signal line crossover occurs when the MACD main line and a Signal lines crosses. The standard interpretation of such an event is a recommendation to buy if the MACD line crosses up through the Signal line. Similarly Sell signal considered when MACD Line crosses Signal line from top to bottom. These events indicate that the trend is about to accelerate in the direction of the crossover.
Because of the high frequency of market noises and spikes, like any predicting algorithm, the MACD Indicator can produce false signals. For example, A false Buy signal would be a bullish crossover (MACD line crosses up through the Signal line) followed by a sudden fall of the market. Moreover, MACD Indicator could not give any signal before significant moves…
An example of a price filter would be to buy if the MACD line breaks above the signal line and then remains above it for three bars(periods). As with any filtering strategy, this reduces the probability of false signals but increases the lag and frequency of missed profitable signals.
Analysts use a variety of approaches for filtering out false signals and confirm true ones.
Also, the popular interpretation of the MACD crossover of the Signal line is that acceleration of the trend is declining, so soon the trend is going to change. The MACD line crossing zero proves Signal line crossover signal and suggests that the average trend is changing direction.
A Zero crossover event occurs when the MACD series changes sign, that is, the MACD line crosses the horizontal zero axes. MACD gains zero values when there is no difference between the fast and slow EMAs of the price series. Change from positive to negative MACD is interpreted as bearish(Sell signal), and from negative to positive as bullish(Buy signal). Zero crossovers provide evidence of a shift in the direction of a trend but less confirmation of its momentum than a Signal line crossover.
A positive Divergence or Bullish Divergence occurs when the price makes a new low relevant to the past movements, but the MACD does not confirm this movement with a new low of its own. A negative Divergence or Bearish Divergence occurs when the price makes a new high, but the MACD does not confirm this moment with it is own high. A divergence between price and MACD may occur when price and MACD histogram shows different directions.
There are a lot of criticism around the internet about standard MACD indicator in Meta Trader 4 and Meta Trader 5.
“The default MT4 MACD indicator lacks the fast signal line (instead of showing the fast signal line, it gives you a histogram of it), this is, basically, excluding half of the indicator itself, and you can no longer see the crossing of the fast/slow lines clearly.
The MACD histogram, which normally represents the difference between the signal lines (the underlying strength of the trend), instead just shows the outline of the non-existent fast signal line (not nearly has helpful).” – http://www.forexfactory.com/showthread.php?t=69409
There are couple free versions of custom MACD indicator on the net.
On the image – two variations of the MACD indicators.