MACD

MACD - Technical Analysis Indicator

The Moving Average Convergence Divergence (MACD) was developed by Gerald Appel in the 1960’s and is a technical indicator using three exponential moving averages, two to illustrate the strength of a trend and one to indicate when a potential trend change is at hand.  We will cover the MACD calculation below.

The MACD is a lagging trend following indicator which illustrates the momentum of a security.  It has no upper or lower boundaries but a move above or below 0 indicates that the short term trend has switched from down to up or up to down.  The zero line tends to act as support or resistance when touched.  

Trading the MACD in a range bound market is not advisable as there tends to be many false signals being created, as with many technical indicators.  Below, we will discuss a few of the popular trading techniques using the MACD; including, MACD divergence, MACD crossover, and the MACD Histogram.

MACD Calculation

The MACD calculation is performed by taking the difference between the fast EMA and the slow EMA and this value is plotted on a graph and can be calculated on any timeframe chart.  The third EMA is the first derivative of the moving average convergence divergence indicator.  This third EMA, also known as the signal line, takes the exponential moving average of the MACD values which have been generated in prior periods.  Most charting applications will plot the MACD and the signal line together to allow traders to visually note the cross.

MACD Calculation

The most common values for the larger and smaller exponential moving averages are 12 and 26 respectively, while 9 periods is the most common look back period for the signal line.

Let's take a look at a live example to understand what we mean by the MACD and the signal line.

MACD & Signal Line Example

MACD Divergence

Many traders use the MACD divergence as part of their overall trading strategy to help portend potential trend changes.  The divergence is created when price is moving in one direction while the MACD is moving in the opposite.  Traders will keep a close eye on long positions in which the price is setting new rally highs but the MACD is not.  This is a bearish sign which indicates a change may be near.  On the flip side, a bullish MACD divergence can form when the price sets lower lows but MACD does not.  It cannot be said enough times, but technical indicators should be used to support your price and volume analysis and should never be done in a silo where trading decisions are made through trading any single trading indicator alone.

MACD Divergence

MACD Crossover

The most commonly used strategy is the MACD crossover.  It is a very simple strategy but should be used with caution.  The crossover buy signal is created when the MACD crosses above the MACD signal line.  Conversely, a sell signal is created when the MACD crosses below the signal line.  This indicator is better applied when it is combined with the MACD divergence as it adds that extra layer of confidence to a trade.

I have also found that trading this signal can be profitable when it prints after the first real pullback off of a strong rally.  For example, suppose that stock A has run from 10 to 20 and then pulled back to 15.  A MACD crossover buy signal at 15 would be a much higher probability trade.

MACD Crossover

MACD Histogram

Being that the MACD is a lagging indicator, the MACD histogram was developed to help traders identify a possible change in trend before an actual MACD crossover occurs.  The MACD histogram plots the difference between the MACD and the signal line. 

MACD Histogram Calculation

The idea here is that a trader will be able to see the spread between the two lines increasing or decreasing as each bar prints.  When above the 0 line, a shrinking histogram can indicate a crossover is imminent.  Conversely, coming from below the 0 line, an increasing histogram can indicate a MACD crossover may be nearing.

Conclusion


The MACD can be a very powerful tool if used in the proper context.  First of all, it can never be used as your sole decision making tool.  It is just one part of the puzzle and can add significant value when confirmed by volume and price patterns.  Secondly, remember that this is a lagging indicator and can get you into a move well after it has begun.  Finally, it is difficult to scale this indicator against previous values due to the fact that it plots the raw difference between two moving averages.  As price moves higher, so does the difference between the moving averages.  Unlike oscillators, this indicator cannot be used to determine overbought and oversold levels.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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