Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD) is a popular and versatile tool used in technical analysis. Developed by Gerald Appel in the late 1970s, it’s a trend-following momentum indicator that shows the relationship between two moving averages of a security's price. Think of it as a momentum dashboard for a stock. Its name sounds complicated, but the core idea is simple: it helps investors identify the strength, direction, and potential duration of a trend in a stock's price. When the moving averages are moving closer together (“converging”), it signals that momentum is decreasing. When they are moving apart (“diverging”), it signals that momentum is increasing. While often associated with short-term trading, the MACD can be a surprisingly useful sidekick for the patient value investor, offering insights into market sentiment and helping to time entries and exits for fundamentally sound investments.

The MACD indicator might look like a messy plate of spaghetti on a chart at first, but it’s made of just three simple parts. Understanding them is key to unlocking its power.

This is the heart of the indicator. It’s calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA of a security's price. Don't worry about the math! Just know this: the MACD line measures the difference between a shorter-term trend and a longer-term trend. When it’s positive, short-term momentum is stronger than long-term momentum, and vice-versa.

This is simply a 9-period EMA of the MACD line itself. Its job is to smooth out the MACD line and make it easier to interpret. The signal line acts as a trigger or a baseline. The most common signals are generated when the MACD line crosses over or under this signal line.

The histogram is the simplest part to understand visually. It represents the difference between the MACD line and the signal line.

• When the MACD line is above the signal line, the histogram is positive (bars are above the zero line).
• When the MACD line is below the signal line, the histogram is negative (bars are below the zero line).

The height of the bars shows how strong the momentum is. Tall bars mean the trend is strong and accelerating; shrinking bars mean the trend is running out of steam.

The interplay between these three components generates signals that can help you gauge the market's mood.

Crossovers are the most basic signals generated by the MACD.

• Bullish Crossover: This occurs when the fast-moving MACD line crosses above the slower signal line. It’s often interpreted as a “buy” signal, suggesting that momentum is shifting to the upside. The histogram flips from negative to positive.
• Bearish Crossover: This occurs when the MACD line crosses below the signal line. This is seen as a “sell” signal, indicating that momentum may be shifting downwards. The histogram flips from positive to negative.

This is arguably the most powerful signal from the MACD. Divergence occurs when the price of a stock is moving in one direction, but the MACD indicator is moving in the opposite direction. It’s like the stock’s price is telling one story, and its momentum is telling another.

• Bullish Divergence: The stock’s price hits a new low, but the MACD’s low is higher than its previous low. This is a classic sign that the bears are losing their grip, and the downtrend may be nearing an end.
• Bearish Divergence: The stock’s price rallies to a new high, but the MACD’s high is lower than its previous high. This suggests the rally is built on shaky ground and is losing momentum, which could foreshadow a price drop.

As value investors, our decisions are rooted in fundamental analysis—understanding a business and buying it for less than its intrinsic worth. We don’t buy stocks just because a line on a chart tells us to. So, where does a technical tool like MACD fit in? Think of MACD not as a crystal ball, but as a barometer for market psychology. It’s a supplementary tool, not a primary decision-maker.

1. Better Entry Points: Let's say you've done your homework. You’ve found a wonderful company selling at a discount. Instead of buying immediately as the price is falling (the classic “catching a falling knife” problem), you could wait for a bullish divergence or a bullish crossover on the MACD. This can suggest that the wave of selling pressure is finally exhausting itself, providing a more opportune moment to start building a position.
2. Confirming a Thesis: If you believe a stock is overvalued and due for a correction, a bearish divergence can provide supporting evidence that the market's enthusiasm is waning. It can help you make a more confident decision to sell or trim a position that has become expensive relative to its fundamentals.

Ultimately, MACD should never be used in a vacuum. It can generate false signals and is, by its nature, a lagging indicator. However, when combined with a rigorous, fundamental-first approach, it can provide valuable context on price trends and market sentiment, helping you execute your value-based strategy with a little more finesse.