MACD Moving Average Convergence and Divergence

Moving average convergence divergence is one of the most consistence and reliable of the oscillators available in the arsenal of the chartists and traders that they frequently use, combined with other indicators to assert the indication, to find the trend and the power underlying trend or the change in the trend. The method of MACD was developed by Gerald Appel. The MACD can be put to use in various method that will be discussed as and when required. But first thing first, let us see how the MACD is calculated or generated. MACD turns the trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Because MACD is unbounded, it is not particular useful for identifying overbought and oversold levels. A word of caution is that generally the MACD is available for plot on the charts, i.e. confuse the MACD and the Signal line with the 12 Day EMA and 26 Day EMA. The EMA both the 12 Day EMA and the 26 Day EMA are the first derivative since they are calculated using the prices directly. MACD = (12 Day EMA 26 Day EMA). The MACD is the second derivative; this is so because it is generated using the difference between the two EMAs. The standard MACD calculation is the 12-day Exponential Moving Average (EMA) less the 26-day EMA. Closing prices are used to form the moving averages so MACD is based on closing prices. As the name suggests and has been accepted by the chartists and technical analysts that the shorter moving average when they move above the longer moving average they signal the bullishness and when the shorter moving average moves below the longer moving average this signals the bearishness in the trend. MACD is all about the convergence and divergence of the two moving averages. Convergence occurs when the moving averages move towards each other. Divergence occurs when the moving averages move away from each other. The shorter moving average (12-day) is faster and responsible for most of the MACD movement. The longer moving average (26-day) is slower and less reactive to price changes in the underlying security.

Another word of caution, dont confuse the divergence of the EMA constituting the MACD with the divergence that occurs between the price and the MACD (as an oscillator). 1. Positive MACD indicates that the 12 Day EMA is above the 26 Day EMA. Positive values increase as the shorter EMA trades further above the longer EMA. This means upside momentum is increasing. 2. Negative MACD indicates that the 12 Day EMA is below the 26 Day EMA. Negative values increase as the shorter EMA trades further below the longer EMA. This means downside momentum is increasing.

3. There are times when MACD crosses the zero line, which is also known as the centerline. This signals that the 12 Day EMA has crossed the 26 Day EMA. 4. To make it simple to remember when ever the 12 Day EMA moves above the 26 Day EMA, the resultant MACD has moved above the center line or the zero line. And whenever the 12 Day EMA moved below the 26 Day EMA, the resultant MACD has moved below the zero line.

The signal line is the third derivative since it is calculated using the MACD which is the second derivative. Signal Line= 9 Day EMA of MACD. Now the signal line being the moving average of the MACD, gives us another method of defining the trend and the underlying strength in it. Take a break here and let us picturise the plain price action and the simple moving averages that we use on the charts. Time tested moving averages provide support and resistance zones, that is to say, when the prices move above the moving average the trend is deemed to be bullish and when the prices move blow the moving averages, the trend is taken to be bearish. Now coming back to the MACD, as a moving average of the indicator, it trails MACD and makes it easier to spot turns in MACD. The signal line is an EMA of MACD and when the MACD converges and moves above the signal line this is taken to be bullish and when the MACD moves below the signal line it is taken to be bearish. Signal line crossovers are the most common MACD signals. Crossovers can last a few days or a few weeks, it all depends on the strength of the move that causes the crossover. Now again as per the requirement and the use of trials one can find out the number of readings to be used for signal line that fit or so to say provide best and consistent results.

Example of centerline crossovers MACD Histogram MACD Histogram is the forth derivative of the MACD series. The histogram is calculated subtracting the signal line from MACD. MACD Histogram = MACD - Signal Line As can be seen in the calculation formula the MACD histogram is an oscillator unto itself. It is an indicator of an indicator. Therefore, it is designed to anticipate signals in MACD, which in turn is designed to identify changes in the price momentum of the underlying security. We use the MACD to find the change in the momentum and the direction and strength of the price trend. The center line crossover is the most raw form and most powerful form of finding strength, but like all good things it is not so common and comes with delay. To overcome this, the signal line is generated to get a before hand knowledge of the change in the direction of the MACD i.e. conventionally the bullishness will be accepted when the MACD has moved above the center line, but the use of the signal lines cautions that the change in the direction of the MACD and intimates that any

bullish or bearish signal, as per the case may be, should be taken with due diligence. Now to get the knowledge of the convergence or divergence of the MACD and the signal line the difference is taken and plotted as the MACD which is even faster than the signal line cross overs.

As with MACD, the MACD-Histogram is also designed to identify convergence, divergence and crossovers. The MACD-Histogram, however, is measuring the distance between MACD and its signal line. The histogram is positive when MACD is above its signal line. Positive values increase as MACD diverges further from its signal line (to the upside). Positive values decrease as MACD and its signal line converge. The MACD-Histogram crosses the zero line as MACD crosses below its signal line. The indicator is negative when MACD is below its signal line. Negative values increase as MACD diverges further from its signal line (to the downside). Conversely, negative values decrease as MACD converges on its signal line. Just like the MACD the Histogram is plotted above and below the center line and to me it is quite pictorial and comes handy. Center line crossovers Center line holds greater importance than all the other aspects of the MACD. A center line crossover signal is second most happening event after the signal line crossovers. A bullish center line crossover occurs when MACD moves above the zero line to turn positive, and this happens when the 12 Day EMA has moved above the 26 Day EMA. A bearish center line crossover occurs when MACD moves below the zero line to turn negative and this happens when the 12-day EMA moves below the 26-day EMA. The use of the center line crossover is healthy signals but they are quite late to signal the change. However the placement of the MACD above and below the centreline tells who are in control of the trend. When the MACD is above the centreline this simply means that the bulls or the buyers are in control of the market and when the MACD is below the center line it means that the bears are in control. Divergences Divergences form when MACD diverges from the price action of the underlying security.

Example of Bullish Divergence

A bullish divergence forms when a security records a lower low and MACD forms a higher low. The low lower in the security affirms the current downtrend, but the higher low in MACD shows downside momentum is veining (or what we can say for instance that the momentum of down trend is decreasing). The slowing of the downtrend sometimes foreshadows a trend reversal or a sizable rally.

Example Bearish Divergence

A bearish divergence forms when a security records a higher high and MACD forms a lower high. The higher high in the security is normal for an uptrend, but the lower high in MACD shows less upside momentum. Waning upward momentum can sometimes foreshadow a trend reversal or sizable decline. Divergences should be acted upon with caution. Bearish divergences are commonplace in a strong uptrend and they generally occur when the price are consolidating, while bullish divergences occur often in a strong downtrend, as was the case in uptrend consolidation formations lead the prices to nowhere which leads the MACD to flatten out or diverge. Uptrend often starts with a strong advance that produces a surge in upside momentum (MACD). Even though the uptrend continues, it continues at a slower pace and this causes MACD to decline from its highs. The opposite occurs at the beginning of a strong downtrend.