Moving Average Convergence/Divergence (Macd)

MACD

In simplest terms, moving average convergence/divergence is an indicator that shows when a short-term moving average crosses over a longer-term moving average. Gerald Appel developed this indicator as we know it today, and he developed it for the purpose of stock trading. It is now widely used for short-term trading signals in stocks, futures, and forex markets, as well as for swing and position traders. It is composed of using three exponential moving averages. The initial inputs for the calculations were a 9-period, a 12-period, and a 26-period. The concept behind this indicator is to calculate a value, which is the difference between the two exponential moving averages, which then compares that to the 9-period exponential moving average. What we get is a moving average crossover feature and a zero-line oscillator, and that helps us to identify overbought and oversold market conditions.

I might add that because traders are now more computer savvy than ever before and because many charting software packages such as RealTick allow traders to change or optimize the settings or parameters, it is easy to change, or “tweak,” the variables in Appel’s original calculations. Traders can increase the time periods in the moving average calculations to generate fewer trade signals and can shorten the time periods to generate more trade signals. Just as is the case for most indicators, the higher the time periods used, the less sensitive the indicator will be to changes in price movements. MACD signals react quickly to changes in the market that is why a lot of analysts, including myself, use it. It helps clear the picture when moving average crossovers occur. It measures the relative strength between where current prices are as compared to past time frames from a short-term perspective to a longer-term perspective.

The MACD indicator is constructed with two lines: One is the 9-period exponential average (slow line), and the other is the difference between the 12- and 26-period exponential moving averages (fast line). In general, when the fast line crosses above the slow line, a buy signal is generated; the opposite is true for sell signals.

The MACD also has a zero baseline component, called the histogram, that is created by subtracting the slower signal line from the MACD line. If the MACD line is above the zero line, prices are usually trending higher. The opposite is true if the MACD is declining below the zero line. The MACD is a lagging indicator; that is, it is based off moving averages. We want to look for the zero-line crossovers to identify market changes and to help confirm trade entries or trigger action to exit a position. As you can see in the e- mini-Standard & Poor’s (S&P) chart in Figure 3.7, the MACD readings cross back above the zero line, indicating a confirmed shift in momentum. That zero-line cross helped filter out the bottoming process. A long position would have been initiated at the close of the candle or at the next time period’s open at 1267.25, which resulted in an immediate price gain, carrying prices up over 1270.

Clues that identify shifts in momentum as the market moves from one extreme to another or from overbought to oversold to trigger a trading opportunity can be identified with the aid of MACD readings in both the moving average and the histogram component. While profits are higher when buying the absolute bottom, that is a haphazard guessing game to play.

Trading based on a set of rules and using a confirming indicator to identify a change in price direction and then following that price movement are the keys to making money in the markets. Figure 3.8 shows an e-mini-S&P example; the intraday trend is established to be higher by 10 a.m., as the symmetry of higher highs and higher lows exists. The MACD confirms an HCD trigger as the histogram bar crosses above the zero line, initiating a long at 1234.75. Notice that the histogram bars continue to expand higher, confirming that the bullish momentum is accelerating. Identifying a zero-line cross is a powerful tool in confirming entries, and watching the progression of the histogram bars may help you maintain a winning position.

It is not in every single instance that we see the MACD signals work exactly the same as Figure 3.9 demonstrates. The histogram was not under the zero line; therefore, a zero-line cross did not trigger. However, observing that the histogram bars move higher as prices start to advance would certainly help confirm the strength of the uptrend.