The MACD indicator is one of the most popular tools in technical analysis, and it’s another tool that we occasionally use in our reports.
Developed by Gerard Appel in the 1960s, the basic idea of MACD histogram is to follow the trend in the market under consideration, with a special hybrid of two different moving averages.
We take two exponential moving averages (typically with periods 12 and 26) and subtract the slower (26 period) from the faster (12 periods) to get the “MACD line”, given in blue in the chart below.
Observe that in this market the faster (brown) moving average is always higher than the slower (pink) moving average, so that the MACD line is always positive.
When the moving averages are closest together, MACD is at its lowest level. As the moving averages get further apart, MACD rises accordingly. And since the faster (brown, 12-day) moving average is always greater than the slower (blue, 26-day) moving average, MACD – the latter subtracted from the former – is always greater than zero.
So what’s the red line beside the MACD line? That’s the Trigger or Signal line, and is the 9-period exponential moving average of the MACD line. That makes it the average of a difference between two averages!
The red line provides us with a handy way to interpret MACD, providing easily recognised buy and sell signals. For example, a trader could take a buy signal whenever the MACD line crosses the signal line from below, or a sell signal whenever it crosses from above. This is really just a more advanced version of taking buy and sell signals whenever moving averages of different periods intersect with each other.
To help isolate the distance between MACD and the signal line, some people plot this distance as a histogram along with the line, like this:
With the histogram in place, we can spot the buy and sell signals whenever it crosses from positive to negative, or vice versa. We can also get early warnings of the signal as we watch the histogram reach highs and lows. When it reaches a high, and starts declining, we know that the sell signal is getting closer; when it forms a low, and starts rising, we know that a buy signal is imminent.
Another way to use MACD is to look for any divergence it has with the price action. This helps us to identify situations where a trend is running out steam – where the price is continuing to move in the direction of the trend, but without the conviction it had before. This principle provides us with early clues of a reversal.
Above is an example of a reversing bull market where the price reached a higher high, but the falling MACD line hinted that all was not well.
As a word of warning, here’s an example of a ranging market where the choppiness means that getting useful buy or sell signals is impossible. In this case we’ve placed the Buy and Sell signals on the days after MACD and the trigger actually intersected, to give a more realistic “worst case” scenario, where we don’t get to execute our trade until the signal is confirmed on a closing basis. As you can see, the results aren’t impressive:
As with everything else, the MACD is not a cure-all. As a trend-following indicator though, it is certainly a useful tool and helps to place any market in a bullish/bearish context, as well as providing us with interesting signals. Whether we are looking for specific crossover trade signals, or just watching how elevated or depressed the MACD line is to tell us how bullish or bearish the market is, it’s something that’s worth keeping an eye on in a wide variety of situations.
Some principles to bear in mind here and with indicators in general:
- Parameters can be adjusted to take into account the particular market you’re trading. If the market you’re in is alternating trend too fast for the MACD to provide profitable signals, adjust the time parameters down to make it more responsive.
- Indicators are always of secondary importance to the price action itself: that means simple support and resistance levels, trendlines, etc.
- All technical tools can and should be used in conjunction with each other. If the MACD signal agrees with each of your other tools of analysis, then you could be onto a winner. But if MACD is telling you one thing, and a candlestick pattern is telling you another, then think twice! (this is a whole subject in itself which we’ll have a go at covering in later blogs).
Graham Neary MSTA (email@example.com)