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Precious metals investment terms A to Z

MACD

MACD (Moving Average Convergence/Divergence) – is a technical analysis indicator based on the discrepancies between moving averages calculated for different periods. Through the use of these moving averages, the MACD generates buy and sell signals.Because of its relatively easy-to-interpret signals, the MACD has become a popular tool among precious metals investors.

Eric asks:

At the end of the trip to a shopping mall, our heroes are passing a fast-food outlet. Eric is hungry and suggests to go in. Jill is shattered by the idea.

Prof. Jill, the Investor

Prof. Jill, the Investor

But Eric! This is junk food!
Eric, the Beginner

Eric, the Beginner

Yeah, so what? It tastes great.
Prof. Jill, the Investor

Prof. Jill, the Investor

Great? We must be living in different taste dimensions…
Read the whole discussion

What is the idea behind the MACD?

MACD is the difference between two exponential moving averages of the prices of an asset. Usually, one is a very-short term moving average, the other a short-term or a medium-term one. Although specific lengths of the moving averages are not precisely defined, it is a rule that one of them encompasses a shorter period than the other. This will become clear as you shift your attention to the chart below (charts courtesy by http://stockcharts.com).

The solid blue line represents the 12-day exponential moving average (EMA), while the solid red line represents the 26-day EMA. As you will notice, usually there is a slight difference between their levels. This corresponds to different purposes for which the EMAs are calculated: the 12-day one reflects the immediate trend and the 26-day one the short-term trend. On the chart above the 12-day, the EMA is higher than the 26-day EMA most of the time. This is a typical situation when the main trend remains up (and this is precisely the case here). The only period during which the 26-day is higher is the end of June/beginning of July, 2011. As you will surely notice, this was a time during which the general trend was temporarily broken by a short-term trend down. This remains in line with the remarks made above.

Now, let’s look closer at the difference between the two EMAs. There are periods in which this difference is more significant than in others. To underline that, we will plot this difference on an additional chart.

The abovementioned difference is reflected by the solid black line on the smaller chart. This is precisely what MACD is – the difference between two EMAs. It would be a logical conclusion to expect the MACD to hit zero when the EMAs are at the same level. In fact, this is the case. Please look at the period when the EMAs crossed one another (June/July 2011). This is the only instance on this chart when the MACD touches zero.

If we have already computed the MACD and plotted it on the smaller chart, what is the use for the additional red line on that chart? This line is the EMA of the MACD itself (a 9-day one to be precise) and it will be useful in generating buy/sell signals (therefore it is often called the signal line). Imagine you want to calculate the difference between the MACD and its EMA (this is pretty much the same process we have already been through with the EMAs) and plot it on the chart. This time, however, the difference is plotted in the form of a bar chart (this chart is often, incorrectly, referred to as a histogram). In points in which there is no difference between the MACD and its EMA, the bar chart will display zero.

The zero level on the bar chart is the threshold for signals. A move from positive to negative values is usually seen as a sell signal, whereas a move from negative to positive values is thought to be a buy signal. The simplicity of this interpretation is (as we have already noticed) the main strength of the MACD.

Recalibrating the MACD

The MACD is usually used to identify trend reversals in the short-term. Because of that, it is a helpful tool for speculation, or to identify appropriate entry/exit points. On the other hand, it may also be used in longer time spans. All you need to do is change its parameters. Instead of the typical MACD [12, 26, 9] you may use a modified version: MACD [50, 200, 50]. This will make the indicator less sensitive to short-lived price swings – the MACD will response only to significant corrections and substantial rallies. The recalibration of the MACD may also work the other way around. Namely, its purpose may be to make the indicator sensitive to daily price changes. To do that, you ought to use a shorter short-term EMA and a longer long-term EMA. For instance, the MACD [5, 35, 5] would be better suited for very short-term speculative purposes. As you can see, changing the EMA of the MACD allows you to switch between different time perspectives. This is extremely important as far as your long-term and short-term capital is concerned.

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