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Moving Average Convergence-Divergence

MACD indicator was developed by Gerald Appel, editor of “Systems and Forecast” journal. Owing to clearness combined with simplicity and efficiency of using the analysis of two averages, this indicator has won great popularity in modern trading practice.

MACD technical indicator is built as difference between two exponential moving averages (EMA) with periods 12 and 26 and is displayed in a separate window of a diagram of histogram type (diagram with columns). Moving average with period 9 is calculated out of the histogram values and affixed to MACD diagram. This moving average is called signal line. As a rule, on overwhelming majority of trade platforms, values originally offered by an author are set by default.

In order to understand the nature of the indicator histogram, let us load exponential moving averages with periods 12 and 26 and MACD indicator onto the diagram.

Note the following points:

1. If EMA(12) is above EMA(26), MACD histogram is above the zero axis.
2. If EMA(12) is under EMA(26), MACD histogram is below the zero axis.
3. When two moving averages cross, MACD histogram crosses the zero axis.
4. When EMA(12) is under EMA(26), and distance between the moving averages grows (marked with the green line), MACD histogram rises higher and higher above the zero axis, i.e. the difference between EMA(12) and EMA(26) increases. If the distance between the moving averages begins reducing, MACD columns get lower.

The following MACD signals are practically used:

• Trend direction
• Crossover
• State of overbuy/ oversell
• Divergence with price.

Trend Direction

It is a quite simple, but at the same time, a very efficient signal to determine the prevailing trend in the market. Let us consider three ways of the signal application.

The first way consists in comparing the current column value with the previous column value. Location of MACD signal line is of no importance.

• When each column in the histogram is higher than the previous one, it is required to look for opportunities to buy.
• When each histogram column is lower than the previous one, it is required to look for opportunities to sell.

The second way consists in comparing columns of the histogram with its signal line.

• When the columns are above the signal line (their values against each other is of no importance), we search for opportunities to buy.
• When the columns are under the signal line (their values against each other is of no importance), we search for opportunities to sell.

The example described uses the first method of determining the current trend by MACD histogram slope. We take the value of the current column in comparison with the previous one into consideration, the signal line location is not accounted. To make the diagram more convenient to read, it is possible to colour the columns in red for down-trend and in green for up-trend.

The third method also consists in comparing the histogram columns and its signal line, but correlation between the columns is taken into account as well.

• If a column is above the signal line and higher than the previous column, it means that the trend is ascending and at the stage of development.
• If a column is above the signal line, but lower than the previous column, it means that the current ascending trend is slowing down.
• If a column is under the signal line and lower than the previous column, it means that the current trend is descending and at the stage of development.
• If a column is under the signal line, but higher than previous column, it means that the current descending trend is slowing down.

Crossover

The signal is built on crossover of the indicator with its signal line: when MACD columns lower below the signal line, one should sell, and when they rise over the signal line, it is required to buy. It is believed that sell signals are stronger if crossover is above the zero axis, while buy signals are stronger if crossover is under the zero axis.

Crossovers of MACD histogram with the zero line upwards and downwards are also used as buy and sell signals, as it is nothing but crossover of two exponential moving averages. If MACD histogram crosses the zero line upwards, we obtain a buy signal, while if MACD histogram crosses the zero axis downwards, we obtain a sell signal.

The figure shows three signals of the histogram columns with the signal line.

Overbuy/ Oversell State

Moving Average Convergence/Divergence is also valuable as an indicator of overbuy/ oversell state. When the short moving average rises essentially higher than the long one, i.e. when MACD histogram grows and reaches its historic maximums, it means that the price of the tool in question must be greatly overcharged, and there emerges high possibility of correction downwards. When MACD histogram falls and reaches its historic minimums, it means that the price of the tool in question must be greatly undercharged, and there emerges high possibility of correction upwards. For signal confirmation it is advisable to wait till the histogram columns cross with the signal line, which we wrote about above.

Price Divergence

When divergence is formed between MACD and the price, it means that the current trend may stop soon. Bull divergence emerges when MACD reaches new maximums, while the price fails to reach them.  Bear divergence is formed when the indicator, unlike the price, reaches new minimums. All the signals should be considered in the price diagram and in the indicator diagram in parallel.

The figure shows the example of convergence with the price (bull divergence) on the left. On the right the example of divergence with the price (bear divergence) is shown.

As for specific features of MACD indicator, it should be noted that it has no clearly defined borders, and in theory the diagram can have arbitrarily positive and arbitrarily negative values. Like all computer indicators, to ensure more efficient market analysis, it is recommendable to employ MACD indicator in combination with other indicators. For instance, to determine the trend prevailing at the market, MACD is suitable for usage together with MA. To determine the market states of overbuy and oversell it is worth adding oscillators, such as Relative Strength Index (RSI), Stochastic Oscillator and others. You will know more details about application of technical indicators in next articles.

Alex Sabodin.
Pro Finance Group Inc.