Moving Average Convergence-Divergence (MACD)
By Marcus Fei

What is it?

Developed by Gerald Appel in the late 1970s, MACD is one of the most popular technical indicators employed by short and long term traders and investors in virtually every financial market today. MACD has also become a staple feature in every computer-based technical trading program and platform.

The MACD value is essentially the difference of a short-term exponential moving average minus a long-term moving average. Tracking the MACD value over time, we will be able to plot a line, known as the MACD line, which fluctuates along a middle zero-value line where the two moving averages meet. The MACD line will turn up when prices start to rise as the short-term moving average will rise more quickly than the long-term moving average. The MACD line will start to flatten or turn down when prices start to decline as the short-term moving average will fall towards and possibly below the long-term moving average. As prices move, the short-term moving average will move away (diverge) and move towards (converge) the long-term moving average and hence the name moving average convergence-divergence. An exponential moving average of the MACD line, which is known as the Signal line, is normally plotted together with the MACD line and carries its own significance (which will be explained below) when used in conjunction with the MACD line.

At TradeSignum.com, whenever MACD is selected, the default values are set at 12 periods for the short-term moving average, 26 periods for the long-term moving average and 9 periods are used for the signal line. A histogram is plotted as well to provide a clearer picture of the difference between the short-term and long-term moving averages.

What is it used for?

MACD is used generally used to provide buy and sell signals in the market and it has also been used to assess strength of trends and provide early warnings of potential reversals.

How to use it?

The first set of signals generated by MACD is to buy when the MACD line crosses above the zero-line from below and to sell when the MACD line crosses below the zero-line from above. The second set of signals generated by MACD is to buy when the MACD line crosses above the signal line from below and to sell when the MACD line crosses below the signal line from above. The bullish example below shows a situation where the MACD line crosses above the zero-line and signal line from below in the same instance and the bearish example shows that they can occur individually.

Bullish Crossovers Bearish Crossovers

 

Using MACD, we can also gauge the momentum of the current market direction. When the momentum in a current market direction starts to fail, positive and negative divergences can be spotted between the price and the MACD levels. Positive divergence, a bullish indicator of a possible market bottom, occurs when the price continues to drop to new lows while the MACD line does not move in tandem and does not record new lows. Negative divergence, a bearish indicator of a possible market top, occurs when the price continues to climb higher to new highs while the MACD line does not gain in tandem and fails to record new highs.

Positive Divergence Negative Divergence

 

Examples below show a combination of MACD signals in effect.

Bullish Combinations Bearish Combinations

 

Important supplementary Buy and Sell rules

According to Mr Appel, supplementing the basic buy and sell signals with the following caveats will often produce more reliable signals.

  • Buy signals are much more reliable when the MACD line has crossed below zero from above at some time since the most recent sell signal. The MACD line does not have to be below zero at the time of the buy signal but it should have been below zero at some time since the recent decline.
  • Sell signals are more reliable when the MACD line has crossed above zero from below at some time since the most recent buy signal. The MACD line does not have to be above zero at the time of the sell signal but it should have been above zero at some time since the recent advance.
  • During strong uptrend periods, typically during the early stages of bull markets, the MACD will retreat during market reactions to a level just above zero instead of going below zero. Like wise, in strong downtrends, MACD may top out just below zero instead of crossing above. In such instances, we may ignore the zero crossing caveat, otherwise, the zero crossing condition should be respected.

Using two MACD combinations

Mr Appel also recommends using at least two MACD combinations for buy and sell signals and in different market environments.

In general, Mr Appel suggests using a faster (more sensitive) MACD for buying and a slower (less sensitive) MACD for selling.

  • In periods of strong uptrends, buy very fast and sell very slow. A 12-26, or even a faster 6-19, MACD should be used for buying and a 19-39 MACD should be used for selling.
  • In periods of neutral to positive, buy fast and sell slow. A 12-26 MACD for buying and a 19-39 for selling.
  • In periods of clear downtrends, buy fast and sell fast. A 12-26 MACD is recommended for buying and selling signals.

Example below illustrates how a faster 12-26 MACD can often provide a earlier entry point and a slower 19-39 MACD can help to stay with profitable positions during a positive markets and prevent premature exits.

Conclusion

As we have seen that MACD can be used in many ways, remembering the caveats and using a combination of multiple MACDs can help us to identify more reliable and profitable signals. As with other technical systems, MACD may be prone to produce whipsaws in non-trending periods and should be used in conjunction with other technical indicators.

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