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Today’s indicator of choice is moving average convergence divergence, or in short MACD. If you are currently trading or considering trading your own account, no matter the instrument of choice: stocks, futures or Forex, you have probably heard about technical analysis and some of its well known concepts: moving averages, Elliot waves, relative strength index or MACD, to name a few.

MACD is a versatile oscillator that can be used for outright buy and sell signals or for gauging a market’s strength. I came across MACD while reading one of technical analysis’ most influential books, Technical Analysis Explained by Martin J. Pring.  However, MACD’s developer is Gerald Appel who describes it in greater detail in his books Technical Analysis: Power Tools for Active Investors, and Understanding MACD.

What is MACD?

First of all, a few words about this indicator’s basics.  MACD is a variation of moving averages crossovers. We have explained moving averages previously, but as a reminder:

•    Simple moving average is calculated by adding the closing values and dividing the sum by the number of periods;

•    Exponential moving average is similar to simple moving average, the difference is that it gives more weight to more recent data (please see related articles from Technical Analysis section)

•    Crossover means exactly what the name implies: the intersection of two moving averages. As a general rule, when the fast (shorter period) moving average crosses above the slow (longer period) moving average, it is considered a buy signal. Conversely, the crossover is interpreted as a sell signal.

A Picture is Worth a Thousand Words

The easiest way to explain a technical analysis oscillator and many other concepts for that matter is to see it displayed on a chart. This definitely applies to MACD, since it is a little more complex than most indicators – it has more elements.  

When you insert MACD on a chart, most charting software give you the default parameters of 12, 26 and 9 for exponential moving averages; however you see only 2 lines plotted on the chart. Where did the third moving average go? There are only two lines because one of them is the difference between the 12 and 26 period exponential moving averages of the security, called the MACD line. The second one is the 9 period exponential moving average of the MACD, also known as the signal line. As you can see below, the chart also displays a histogram and a zero line. Moreover, reading MACD involves being aware of signals given by crossovers and divergences.  Let’s take MACD’s elements one by one.

MACD Line

As you can see, the blue (MACD) line is the difference between the 26 and 12 period EMA (pink and magenta lines).  MACD line crosses the zero line above or below when the 26 and the 12 period moving averages intersect, meaning that the difference between them is 0. When MACD moves from below 0 to positive territory, the trend is viewed as bullish. Conversely, when MACD moves from positive to negative the price action is viewed as bearish.  However, this type of cross, above or below 0, is less significant, since it only shows the direction of the trend, but no further details regarding the strength of the trend. A MACD crossing above or below the 0 line is similar to a plain moving averages crossover.

Signal Line

The red line is the 9-period EMA of the MACD. This EMA is also known as the signal line, since a cross of the blue line above the red line indicates a buy signal and a cross of the blue line below the red line indicates a sell signal. Conflicting signals are usually not reliable, such as a downward crossing during an uptrend.

Histogram

A histogram has vertical bars that measure the difference between the two exponential moving averages values, in essence it measures the weakening or strengthening of the trend. The purpose of the histogram is to show the distance between MACD and signal line. The histogram has a zero line for when the difference is null. When the histogram reading is extreme, either positive or negative, then the distance between the lines is greater, and an opposite signal is not likely to be received soon. If the histogram reading is moving from a positive reading towards 0 than an uptrend is weakening.  A downtrend is weakening if the reading moves from negative towards 0. From this point of view, MACD is similar to relative strength index (RSI), which is an indicator that measures the strength of a market against itself.

Divergence

Divergences are noticeable when analyzing the histogram’s peaks and valleys and compare them with the stock’s trend. A bullish divergence takes place when the stock’s price makes a new low but the indicator does not follow suit, meaning does not make a new low. On the other hand, a bearish divergence takes place when the price trend makes a new high but the histogram does not comply. As the names imply, a bullish divergence means that there is more potential for price appreciation while a bearish divergence suggest that the prices will decline. Traders can also spot divergences when noticing contradictory readings between MACD (blue) line and the stock’s price.

Conclusion

MACD seems to work well on longer time frames, such as weekly. Although MACD gives fewer signals a year, they tend to be more reliable. As a general rule, it is important to double check that the daily signals are aligned with the weekly signals. As mentioned earlier, most default settings for MACD are 12, 26 & 9, but you can customise this indicator. MACD’s developer, Gerald Appel, recommends different sets of parameters:

•    8, 17 and 9 exponential moving averages for buy signals

•    12, 25 and 9 combination for sell signals.

Another technical analysis guru, Martin J. Pring suggests applying additional filters:

•    Overbought and oversold lines

•    MACD price patterns such as head and shoulders

•    Paying close attention to price divergences.  

MACD is a useful tool for trend following – MACD buy or sell daily signals, backed by weekly signals. Contrarians like divergences for options writing strategies or exiting a trend following position before giving back a significant part of the gains.

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