What Is Moving Average Convergence Divergence?
Moving average convergence divergence (MACD) is a technical indicator used to identify the price trend of a FOREX currency pair, such as euro/U.S. dollar (EUR/USD). Currency is always traded in pairs: the numerator is the currency you buy, the denominator represents the sold currency. MACD is a form of technical analysis -- the prediction of future prices using past data. MACD relies heavily on moving averages - the running average of the previous n-number of time periods (typically, an hour). To be more precise, MACD relies on two moving averages ("fast" and "slow") of the difference between two other moving averages to identify a trend.
Think first of a simple average, say of the last 26 hourly prices on the EUR/USD currency pair. If you sum the prices in the collection and divide by 26, you have the average price for the collection. Let an hour elapse and do it again. What has happened is that the oldest price has fallen out of your price collection, replaced by the most recent price. Assuming the oldest and newest prices are different, the price collection will have a new average each hour: the moving average of the latest 26 periods. The effect of a moving average is to create a plotted line that "smooths" out the actual hourly price action. The greater the number of periods in the average, the slower the responsiveness of the moving average to changes.
You start with two primary moving averages of hourly prices of a FOREX currency pair. The first is the average of the last 26 hourly prices; the second is the 12-period moving average. You create the fast average difference line (FADL) by subtracting the 12-period average from the 26-period average. Now, take the nine-period moving average of the FADL and you have the slow average difference line (SADL), which functions to smooth out the FADL.
A histogram is a simple XY graph of vertical lines representing the distribution of data. Our histogram plots time on the X-axis and the differences between the FADL and the SADL (the MACD band) on the Y-axis. Superimposed upon the two average difference lines, you will notice that the height of the MACD band will shrink (converge) and grow (diverge) periodically over time. This is the key to interpreting MACD. Note that the different price collections (9, 12 and 26 periods) and the length of the time period (one hour) can be varied, or tuned, as a trader sees fit - the effect is to change the responsiveness of MACD to current prices.
When the FADL crosses the SADL, the difference between the two is zero. As the FADL diverges from the SADL, the histogram height grows. MACD posits that a trend has started when the FADL crosses the SADL and the histogram grows rapidly. When the FADL falls below the SADL on increasing histogram height, MACD is calling for a new downtrend. Conversely, an uptrend occurs when the FADL pierces the SADL from below as histogram height rapidly grows. Because the MACD relies on moving averages of moving averages, it tends to be to lag other technical indicators. Traders therefore view it as a confirmation of a trend that may already have been recognized by other indicators.