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The Moving Average Convergence Divergence: MACD

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Moving Average Convergence Divergence: MACD

The MACD is a superior derivation of moving average crossovers and was developed in 1979 by Gerald Appel as a market-timing tool.

MACD employs two exponential moving averages with different bar periods which are then subtracted, forming what Mr Appel calls the Fast Line. A 9-period moving average of the fast line creates the Slow Line.

How to build the standard MACD:

  1. Find the 12-period Exponential Moving Average of the prices (usually the Close)
  2. Determine the 26-period Exponential Moving Average of prices
  3. Subtract 2 from 1. That will yield the fast MACD line
  4. Compute the 9-period Exponential Moving Average of 3. This value renders the slow Signal line.

Most charting packages facilitate its users the customisation of these parameters, as well as the price type (Open, High, Low, Close, or an average of all).

LeBeau and Lucas, on their classic book “Computer analysis of the Futures Market”, tell that Gerald Appel suggested two setups: One for the entries and another one for the exits.

For the entries, he recommended  8-17-9 as parameters, and a relatively slower closing side 12-26-9: the later has become the standard for commercial charting software.  That appears to indicate that Gerald Appel considered more attractive to enter earlier in the trend, and, then, holding winners longer to let profits run.

(My preference for intraday trading is 12-26-6, smoothing the signal line with a 6-period EMA. This combination reduces the indicator’s lag, producing earlier entries, but keeping the short-term and long-term EMAs distance.)

It’s a good idea to optimise the MACD for a particular market, although with moderation. Overall I think a quicker formula is better for less than average volatility markets, while volatile markets would require much longer periods and the help of a cyclic overbought-oversold indicator such as the Stochastics. So the MACD shows market direction and the stochastics the trigger signal on only that direction. As a way of example, the best-suited parameters to use with DAX Futures 3-minute charts is 20-60-9 in combination with a 5-period stochastic crossover.

Interpretation:

The price implies a consensus of value at a particular time. A moving average is a mean consensus over that period. A long-period EMA on a MACD manifests the longer-term consensus, while the short period EMA denotes a fresher consensus that is emerging.

The results of the average subtraction that shape the fast MACD line unveils shifts in the short-term price evaluation compared to the longer term (older) consensus.

Signal Crossovers

The most usual MACD signal is the crossover of fast MACD line with the signal line. When the fast MACD line moves above the slow signal line, it indicates the beginning of a bull price cycle. If the fast MACD line goes below the slow signal a bearish or corrective cycle has begun.

We have to be careful when trading the naked MACD crossovers because during horizontal price action on quiet channels the crossovers deliver false signals. Nevertheless, we will present several interpretations of the MACD indicator that will help us improve its reliability.

 

Fig 1- MACD Crossovers on the EURUSD 240 min pair.

Fig. 1 presents an example of the EUR/USD 4-hour chart. There, we may observe that pink – unproductive- areas are usually crossovers going against the trend, that take place in reactive trend segments with sideways price movement. In spite of those failed entries, MACD crossovers are an effective way to spot trend changes.

Overbought-Oversold indicator

The MACD can be employed to recognise when the price is overbought or oversold. As an illustration, on the EURUSD above, when MACD lines move above +0.003, the market is approaching overbought levels. Conversely, when MACD lines cross below -0.003 the price is close to a turning point. Hence, we should tighten our stops or partially take profits.

When we find crossovers in these areas entries have higher success chances. Conversely, crossovers happening near the zero level tend to be false signals, especially so if it’s opposing the current trend. Nevertheless, a MACD crossover that goes with the trend with confirmation such as a breakout on a support or resistance zone should be watched.

The MACD sends a very powerful signal when we first see a crossover against the previous price action which fails and then a crossover in the trend direction (see fig 2, points E and F).

As an illustration, let’s see on Fig.2 the MACD in action on the USDJPY pair. at A, the MACD line crossing indicating a short in the USDJPY is close to the zero line, but it happens after a relatively long bullish MACD leg and failing to cross the zero line. Therefore it is an excellent short signal. Then at B, we find a buy signal happening at oversold levels. This should make us close the short and wait for a confirmation to go long, which might have been the candle with the large lower wick close to B. Then at C there is a crossover that will be a good exit place for the long trade, but not to short the pair because it happens against the trend.

Then we see that the crossover did no follow up and it signals a continuation. We have said earlier that this signal is a powerful continuation pattern, and here it was, fulfilling our expectations. D was an exhaustion point and a good place to exit longs. With the strong movement, we could reverse and go short or wait for a confirmation on a break of the lows of the long candle at D. The later would have been the best action to take but the MACD crossover was a good sign of a price top.

As the MACD continued to move downwards, we observe the price making a double top that is matched by a turning point to the downside on the MACD. That would have been a good entry point as it shows an increased momentum to the downside.   E flagged with precision the exit of the short sell.

Finally, F   showed again the kind of “failure to continue” on the MACD and an excellent entry for another short with yet another market-timing exit at G.

 

Trend lines on the MACD

MACD trend lines
A modification of the crossover signals is accomplished using trend lines. By tracing lines parallel to the signal lines, we get entry points earlier than with the MACD crossovers. LeBeau and Lucas state in their book that MACD crossovers preceded by, or in sync with, a trend line crossover tend to show higher reliability. I have no evidence of this on intraday timeframes, But, since all indicators show inevitable delays that cut profits, I believe the use of trend lines on the MACD it is worth studying.
I Also believe that this methodology is an attractive addition when the price moves in sideways channels together with the notion of overbought-oversold MACD, and the supplement of targets at congestion levels.

Fig 3 shows a sample, obtained of a very irregular horizontal price channel on a USD/JPY 1H chart from 28-Sept-2017 till 10-Oct-2017. The green highlighted regions present profitable trades. There’s only one rosy-shaded part that marks a failed trade. That’s a huge achievement! Only one failure out of 11 positions on a very choppy price segment.

MACD Histogram

MACD histogram depicts the separation between the MACD line and its signal line as a histogram, vertical bars whose lengths correspond to that difference. MACD crossovers match the MACD-hist crossing the zero line. Histogram bars above the zero line match the MACD line above the Signal line, and below-zero values, conversely, match the MACD line below the Signal line.

MACD-hist = MACD line – Signal line

When the difference grows, indicating the trend’s momentum rises, the corresponding line is larger. Conversely, when it’s contracting, bars shorten, providing an early indication of a possible vulnerability of the current trend.

Hence, positive and negative peaks on the histogram match the greatest strength of the trend, and a retreat from the highest values reveals a shift in sentiment that might end the trend.

Therefore, it’s advantageous to trade in sync with the slope of the histogram, because it is showing the underlying activity of the dominant group: Bulls if the slope is positive, bears if negative.

A deduction from this observation is: On an open trade if the MACD histogram is descending, tighten your stops. That doesn’t imply the trend is reversing but it might, particularly if prices are moving on a horizontal channel.

New Peaks and Valleys

When the MACD histogram reaches a new record peak in an uptrend, it confirms the strength of the actual trend. Therefore, and prices are expected to keep moving up. A New record valley in a downtrend suggests that prices most probably will retest the recent bottom or continue falling.

Dr Elder has a great analogy to the MACD histogram: “MACD-Histogram works like headlights on a car—it gives you a glimpse of the road ahead. Not all the way home, mind you, but enough to drive safely at a reasonable speed.

Divergences

Divergences are among the most significant MACD signals, particularly when the price is moving in horizontal price bands. A divergence occurs when a new high or low appears in the price, but it isn’t reflected by a similar high or low on the MACD lines.

Bullish Divergence

This pattern appears in the final stager of a descending price movement, and, is a bottoming indicator.
Please observe that the MACD histogram has crossed the zero line at b. Point c can appear in the upper side, as in here, or in the lower side, but presenting a valley higher than at the a point. For the pattern to be called divergence, the crossing of the zero line must happen. If it didn’t appear that way, it’s not a bullish divergence.

A signal line divergence reinforces the divergence in the MACD histogram. A combined pattern like that is rare – the prevalent pattern is just a MACD histogram divergence with its lines not following. This combination presents a greater probability that the new trend would be strong.

Bearish Divergence

A bearish divergence is the counterpart of a bullish divergence. Therefore it occurs in the latest stages of a bullish movement. The price has attained a new high, comes back and then moves up again to a higher high, with no confirmation no of a higher high on the MACD histogram. As it happened in the previous chart, the b point must cross the zero line, in this case to the lower area.

Fig. 6 exhibits a triple bearish divergence on the histogram; its middle peak failed to continue going down. When the second big top at C isn’t followed by a new high on the MACD Histogram and, also, on the MACD signal, the bearish divergence is established.
Alexander Elder says that “missing the right shoulder” divergences in which the second top at c fails to pierce the zero line, are rare, but producing powerful downward trends.

Conclusions

Although all indicators are lagging the price action, the subtracting nature of the MACD also subtracts a substantial part of the inherent lag and allow traders to detect the beginning of a trend reversal at its beginning, aligning them with the next trend.
I’ve tested a lot of mechanical systems in the past, and the combination of MACD and a fast oscillator such as a 5-5-3 Stochastics study, aided with sensible stops and targets, has performed quite well, showing significant statistical results.

The use of a filter banning the trades during congesting areas can help a lot achieve greater results using the MACD. One good solution is to avoid trading when the Bollinger bands start shrinking. The other one is the use of the ADX and DMI study.

 


References:

The New Trading for a Living, Alexander Elder

Computer Analysis of the Futures Markets, Lucas and LeBeau

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