How the MACD Generates Good Trading Signals

Paul Wallace
 
Here’s a trend-following momentum indicator that shows the relationship between two moving averages of prices. The MACD (which can be pronounced as either "mac-dee" or "m-a-c-d") was invented by Gerald Appel in the 1970s. Thomas Aspray added a histogram to the MACD in 1986, as a means to anticipate MACD crossovers, an indicator of important moves in the underlying security.

The indicator has 2 lines which can be given different colors each, a histogram or bar chart which calculates the difference between the two lines. The period for the moving averages on which an MACD is based can vary, but the most commonly used parameters involve a faster EMA of 12 periods, a slower EMA of 26 periods, and the signal line as a 9-period EMA of the difference between the two. It is written in the form, MACD (faster, slower, signal) or in this case, MACD (12,26,9).

The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. A 9-period EMA of the MACD, called the "signal line", is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.  Truly, values are calculated from the price of the instrument in the main part of the graph.

Mathematically:

1. MACD = EMA[stockPrices,12] – EMA[stockPrices,26]
2. Signal = EMA[MACD,9]
3. Histogram = MACD – signal
Traders recognize three meaningful signals generated by the MACD indicator.
When:

A). the MACD line crosses the signal line
B). the MACD line crosses zero
C). there is a divergence between the MACD line and the price of the instrument or between the histogram and the price of the instrument
 
Characteristics of MACD

You’re advised to go check this great indicator in your trading platform and apply it on a chart. You may also examine its parameters, levels, colors and so on. It’ll now be helpful to delve deeper into some characteristics of the MACD.
 
Signal–line crossover: Signal–line crossovers are the primary cues provided by the MACD. The standard 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. Respectively, they indicate that the trend in the pair/cross is about to accelerate in the direction of the crossover.

The histogram shows when a crossing occurs. Since the histogram is the difference between the MACD line and the signal line, when they cross there’s no difference between them. The histogram can also help in visualizing when the two lines are approaching a crossover. Though it may show a difference, the changing size of the difference can indicate the acceleration of a trend. A narrowing histogram suggests a crossover may be approaching, and a widening histogram suggests that an ongoing trend is likely to get even stronger. While it’s theoretically possible for a trend to increase indefinitely, under normal circumstances, even pairs moving drastically will eventually slow down, lest they go up to infinity or down to nothing.

Zero crossover: A crossing of the MACD line through zero happens when there’s no difference between the fast and slow EMAs. A move from positive to negative is bearish 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.

Divergence:  The third characteristic, divergence, refers to a discrepancy between the MACD line and the graph of the instrument 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 pair price hits a new high but the MACD doesn’t. This is interpreted as bearish, suggesting that recent price increases will not continue.

Divergence may also occur between the pair price and the histogram. If new high price levels aren’t confirmed by new high histogram levels, it’s considered bearish; alternatively, if new low price levels aren’t confirmed by new low histogram levels, it’s considered bullish. Longer and sharper divergences—distinct peaks or troughs—are regarded as more significant than small, shallow patterns.

Timing: The MACD is only as useful as the context in which it’s applied. An analyst might apply the MACD to a weekly scale before looking at a daily scale, in order to avoid making short term trades against the direction of the intermediate trend. Analysts will also vary the parameters of the MACD to track trends of varying duration. One popular short-term set-up, for example, is the (5,35,5).

False signals:  Like any indicator, the MACD can generate false signals. A false positive, for example, would be a bullish crossover followed by a sudden decline in an instrument. A false negative would be a situation where there was no bullish crossover, yet the instrument accelerated suddenly upwards. A prudent strategy would be to apply a filter to signal line crossovers to ensure that they will hold. An example of a price filter would be to buy if the MACD line breaks above the signal line and then remains above it for three days. As with any filtering strategy, this reduces the probability of false signals but increases the frequency of missed profit. Analysts use a variety of approaches to filter out false signals and confirm true ones.
 
Further Notes on MACD

The MACD is an absolute price oscillator (APO), because it deals with the actual prices of moving averages rather than percentage changes. A percentage price oscillator (PPO), on the other hand, computes the difference between two moving averages of price divided by the longer moving average value. While an APO will show greater levels for higher priced securities and smaller levels for lower priced securities, a PPO calculates changes relative to price. Subsequently, a PPO is preferred when: comparing oscillator values between different securities, especially those with substantially different prices; or comparing oscillator values for the same security at significantly different times, especially a security whose value has changed greatly. A third member of the price oscillator family is the detrended price oscillator (DPO), which ignores long term trends while emphasizing short term patterns.
 
Conclusion
As a means of emphasis, traders also watch for a move above or below the zero line because this signals the position of the short-term average relative to the long-term average. When the MACD is above zero, the short-term average is above the long-term average, which signals upward momentum. The opposite is true when the MACD is below zero. As you can see on your own chart, the zero line often acts as an area of support and resistance for the indicator. When applying the MACD to your trading, you may use it in conjunction with another useful indicator so that you’ll make better informed trading decisions. If the markets conditions aren’t favorable or things are seriously consolidating, then you may stay out for a while. Additionally, why waste one’s precious mental capital of constantly monitoring the markets unless the odds are stacked in one’s favor? Take the day off if only mediocrity is available.
 
Ever heard the saying, “buy the rumor, sell the fact”? Do you ever wonder why prices go down after a positive announcement? Do you think the Smart Money knew the facts or the good news beforehand and the reason why they’re already long? I think so. So when the good news is announced to the market all the weaker hands jump in and start buying and the Smart Money take the opportunity to offload their positions into the demand strength. Sometimes a market can be predicted easily and sometimes it mayn’t be easy to predict. I heard a great analogy once:

 “If you see a thousand people walking around a shopping mall, it’s impossible to know where they will all be in 5 minutes time. It’s too complex to predict and calculate (yes, even with fractal mathematics). On the other hand, if you set off the fire alarm, it becomes very simple to predict where they will all be in 5 minutes time”.

So it’s with the markets, there are times when it’s easy to push people around because so many have shown their hands. People have put their stops in a big cluster and they’ll all run for the exits when the market moves there. 
 
This article is concluded with a quote from Dr. Woody Johnson:
 
“The fact of the matter is the market is only a neutral representation of the price action; there is no pain in nor created by the market. It is only in the head of the trader. Also, there are traders who think that the market is "against them," and that it is a fight. However, if there is a fight, it is with yourself. The fight with yourself is caused by the internal conflicts. These internal conflicts are in the form of unconscious limiting beliefs that drive thoughts about the price action and about yourself.”