Technical Analysis - MACD

Description: Technical Analysis, MACD, Exponential Moving Average, EMA, MACD Histogram, Signal, moving average, trading

The abbreviation, MACD, stands for Moving Average Convergence / Divergence. MACD is a commonly used indicator in technical analysis. It was created by Gerald Appel in the 1960s. The MACD calculations are very simple and are based on the exponential moving average (EMA):

MACD = Fast Exponential Moving Average – Slow Exponential Moving Average.

From the formula above, you can see that MACD is the difference between two moving averages (MAs). The fast moving average is a moving average with a shorter bar period setting and the slow moving average is a moving average with a longer bar period setting. Basically, MACD reveals shorter-term trend changes (reflected by the fast EMA) in relation to the longer-term trend (represented by the slow EMA).

The most commonly used bar period setting is 12 for the fast EMA and 26 for the slow EMA. Yet, it would be wrong to say that this setting works in all timeframes and for all stocks. This setting was used by Gerald Appel in the 1960s, a half century ago. The stock market is always changing and we should be cautious in referring to 50-year old research. In 1960 all traders applied MACD to daily data, whereas now, we have various intraday analysis techniques, in addition to daily technical analysis. In the 1960s, we had a lower trading volume than we have now and less volatility than we have now. All of this puts into question the advisability of using an indicator setting that was recommended half a century ago for the current market. The current thinking about indicator settings is that it depends on one’s personal trading style and, in particular, on how many trades (signals) one hopes to generate. It is highly recommended that you back test various settings on historical data before applying any of them to real trading.

As a rule, the MACD is always used in junction with a signal line that is an exponential moving average applied to the MACD (a simple MA also could be used). The 9-bar period setting is a traditional setting of the signal line. The difference between the MACD and signal line forms the MACD Histogram, which was first used by Thomas Aspray in 1986.

MACD is considered to be a lagging technical indicator (a trend-following indicator). It was developed to confirm trend reversals and define points of safe entry to the market. There are three ways of using the MACD to generate trading signals:

1. When the MACD crosses the center line (zero line);
2.  When the MACD crosses a signal line in the same way as the MACD Histogram crossing the center line (zero line);
3.  On a divergence of the price and the histogram, or of the MACD line and the price.

MACD and Center Line Crossovers.

As mentioned above, the MACD reveals where the shorter-term trend is in relation to the longer-term trend. Based on this, technical analysis says that, if a fast EMA moves above a slow EMA (MACD is positive in this case), we are witnessing an up-trend. Conversely, when a fast EMA moves below a slow EMA, we are witnessing a down-trend. Furthermore, the MACD is considered to be Bullish when it is positive and Bearish when it is negative. A trading system may use the crossovers of the MACD and zero line (center line around which the MACD oscillates) to generate trading signals. In particular, a "Buy" signal can be generated when the MACD crosses zero on its way up and a "Sell" signal can be generated when the MACD crosses the zero line during its fall.

MACD and Signal Line Crossovers.

When the MACD crosses a signal line, it is the same as if the MACD Histogram crosses the center line (zero line).

This is the most commonly used way of generating MACD-based signals. It allows signals to be generated more quickly than when they are generated on the crossovers of the MACD and the center line. Technical analysis says that when the MACD starts to decline after being at high levels, the fast EMA has started to drop closer to the slow EMA and may cross it in the near future. The signal line is an exponential moving average applied to MACD, which on a chart looks like a shifted MACD line. When the MACD crosses the signal line on its way down, a technical analyst may conclude that the down-trend has become strong enough to sell short. Controversially, when the MACD crosses the signal line on its way up, it tells us that the fast EMA has moved far enough up to assume a stable up-trend and to consider buying.

Divergence between the price and the histogram, or between the MACD line and the price.

Positive divergence between the MACD and the price is noted when the price reaches a new low. However, the MACD doesn't reach a new low by staying above the level it fell to on the previous price low. In technical analysis, this is considered to be a bullish signal, suggesting that the downtrend may be close to a reversal. Conversely, negative divergence arises when price makes a new high, yet the MACD does not rise as high as it was before and this is considered to be a bearish sign.

Divergence may be similarly interpreted on the price versus the MACD histogram, when the new price levels are not confirmed by new histogram levels. Longer and sharper divergences (distinct peaks or troughs) are regarded as being more significant than small shallow patterns in this case.

 

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