# Moving Average Convergence Divergence (MACD)

Before leaving the section on moving averages, we must just talk about the moving average convergence divergence indicator, conveniently shortened to MACD, which is pronounced “mac-dee”. This elaborates on the crossover system of moving averages, so can give you trading signals, but rather cunningly can give you them in advance. This was technical analysis or charting technique invented by a trader called Gerald Appel in the late 1970s.

The technique is used to attempt to predict changes in trend of the price of a market, whether you’re trading foreign exchange, stocks, bonds, indices or a whole range of other financial markets. Spotting and ‘boarding’ a trend is the Holy grail for traders, enabling them to profit from a long-term move in the price essentially in one direction-either up or down.

We’ve seen that you can use the crossing of two moving averages to give a trading signal. In his indicator, Appel uses exponential moving averages (EMA), but it is the same principle. The frustrating thing about the double crossover method is that you can often see the moving averages getting closer, but still not have the signal that allows you to “pull the trigger” and place a bet. Sure, you can anticipate the event, but then you have stepped outside of your trading plan and can’t expect consistent results. Besides, you will kick yourself if you trade early and the averages don’t cross, and you are in a losing bet. So what to do?

What Appel thought about was the approach and retreat of the moving averages, the convergence and the divergence – hence the name. Before two lines cross, they must converge on each other; when they are moving apart, they diverge. If you quantify these factors, rather than waiting for a crossing you can get an early warning of the possibility of a crossing. The MACD is usually plotted below the main price chart, and is a solid line showing the difference between the two different EMAs. So when the line is at zero, it means that the EMAs are the same number, i.e. crossing each other. Here’s a chart showing the MACD line: –

Well, that in itself doesn’t help much – when it hits zero the moving average lines are crossing, but then we could always look at the lines to see when they cross too!

But taking it one stage further, Appel also plotted a moving average of the MACD line (usually an EMA(9) line shown dotted), and this line anticipates the crossing of the zero line, giving an earlier signal. Here’s the chart of that: –

This is how you will usually see the MACD plotted, with a dotted line which is called the signal line. When the signal line drops below the MACD line, this is a buy signal. If you look closely at the chart, you will see that this occurs before the actual moving average crossings, giving you the signal to bet in advance.

You can also take the crossing of the line as a signal to close the bet, and if you follow through on the chart above you will see that this usually means you close early, before the retracement becomes evident. In fact if you look through the movement of the MACD it appears almost to be predictive in its powers, and this means that it is very popular amongst traders.

## How does it work?

The Moving Average Convergence Divergence process first involves computation of two moving averages, (usually exponential), over different time periods. There’s no brainpower required in this – most trading platforms will calculate and display them for you. For example one may be a moving average, (Ma), of the closing price of a particular Foreign Exchange price on 12 consecutive trading days, (the ‘faster’ average; being the blue line in the upper chart, of new Zealand dollar vs. US dollar, shown above), and the other the moving average over 26 days, (the ‘slower’ average; the pink line in the upper chart).

The method then analyses the difference between the two Ma’s and then plots that as another line-known as the MaCd line-this is represented by the red line on the lower chart. Finally a Ma of this difference is also in turn calculated-the green line on the lower chart, also known as the signal line, and superimposed on the MACD (red), line. (The histogram on the lower graph is another representation of this difference).

## So what are the signals to look for?

Traders watch for three different signals generated by the MACD technique to spot trend changes. The first is when the MACD line crosses the signal line, i.e. the red line crosses the green line.

Second, when the MACD line crosses zero, i.e. the red line crossing the x-axis the straight black line in the middle of the lower chart). Third, if there is a divergence between the MACD line and the price of the stock, i.e. higher highs, (or lower lows) on the price graph but not on the red line.

But the chartists are also looking for signal line crossover, and there are three to be aware of. These crossovers are the strongest signals generated by the MACD charting technique. The normal interpretation is to buy when the MACD line crosses up through the signal line, or sell when it crosses down through the signal line. The upwards move is called a bullish crossover and the downwards move a bearish crossover.

A zero crossover occurs as a crossing of the MACD line through zero. if it’s from positive to negative it’s a bearish signal and from negative to positive, bullish. Zero crossovers provide evidence of a change in the direction of a trend, but less confirmation of its momentum than a signal line crossover.

The third signal is divergence, and this refers to a divergence between the MACD line and the graph of the stock price. Positive divergence between the MACD and price arises when price hits a new low, but the MACD doesn’t. This is interpreted as bullish, suggesting the downtrend may be nearly over. negative divergence is when the stock price hits a new high but the MACD does not. This is interpreted as bearish, suggesting that recent price increases will not continue.

Of course, the key decision to be taken when constructing an MACD analysis is how many trading periods should one use to construct the Mas; in the example above we used periods of 12 and 26 days, but 6 and 16 is also a common combination and successful traders will evolve a favourite coupling as a result of extensive back-testing and experience.

## When do I make my move?

The trader will have the strongest confidence that he/she has spotted the start (or end) of a big trend when all three indicators are activated.

There are other things to be learned from the movement of the MACD line. We’ll come to oscillators as such in the next section, but the MACD line pre-empts that discussion as it also acts as an oscillator, indicating overbought or oversold conditions. When the MACD line is high above the zero, it tends to indicate that the security is overbought, which means that traders may have exercised irrational enthusiasm in building up the price to an unsustainable level. This often means that the price will come back down shortly.

In a similar way, when the MACD line is well below the zero, the security may be considered oversold. This means that traders have sought to close the positions, almost regardless of price, and a prudent observer may expect that the price will settle back up to a more reasonable level.

You may notice that the MACD line looks quite similar in profile to the price line. This is what you should normally expect. Whenever an oscillator diverges markedly from the price trend, it may be giving you warning of an impending change.

It’s possible to read a lot of things into the MACD line and its accompanying signal line, and much of the time it provides useful evidence. It is not magic, and it is based on moving averages so anything that would cause moving averages to mislead you, such as a price jump, will also affect the MACD indicator and give you false information.

If you find it difficult to read what the MACD indicator is telling you, apart from at the crossovers, you’re not alone. There’s another little trick that was invented to help you work out what the MACD is trying to say. That is by showing the numbers as a histogram, or type of bar chart, as you can see below: –

This sets a new dimension to interpreting the patterns. The histogram is the difference between the two moving averages, so when the signal and MACD line are crossing there is no bar up or down, the value is zero. At a glance you can see whether the lines are converging or diverging, and how strongly. Effectively this puts another dimension on the converging and diverging idea. If the size of the histogram reduces, then it’s an indication that the trend is weakening and losing momentum. And this must come before the lines converge and cross, giving you extra warning of an imminent crossing.