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Moving Average Convergence Divergence (MACD)

 

Referred to as “Mac” “D”, its a momentum indicator to highlight the relationship between two moving averages.

 

Unlike the other indicators I use that can be fairly easy to comprehend (why I like them), the MacD can be a bit more cumbersome. By cumbersome I really mean it can tell a few different stories depending on which direction you look. They are…

 

The 3 MacD perspectives;

  1. Divergence from Price method
  2. Crossover method
  3. Overbought/Oversold method

And now that we’re aware, let’s look at each separately.

 

Please note – MacD much like the moving averages are of little use when markets are range bound.

 

Divergence from Price Method

 

Stated a simply as I can, divergence is apparent when prices are moving higher and the signal lines of the indicator are heading lower. Or vise versa. This method of looking for divergence’s can provide an early warning for when the market will top or bottom out, thus signaling a reversal.

 

I’ll illustrate with a picture.

 

Click to Enlarge.

Macd Divergence
Divergence Analysis

 

Take a look at the grey highlighted section. In this example it becomes glaringly apparent that Delta is experiencing a price divergence. I’ve highlighted the last two instances with bold yellow lines for your benefit.

 

Notice on 1/11 the MacD histogram appears to have bottomed out, but price keeps moving down for nearly a month. During this period we should keep a watchful eye on Delta for our signal to enter. Our signal came on or around 2/12 when the blue MA line crossed the yellow signal line. Had a long position been entered we would have been rewarded handsomely as Delta shot up about $6 in price.

 

The second instance depicted above is happening as I write this article. On 2/23 the MacD histogram is topping out but the price continues higher. Albeit only slightly. Then on 3/24 we’re greeted with an opportunity to enter a trade to the downside.

 

As with all technical indicators, it isn’t perfect. It can a will fail. Just take a look on 3/6 as the MacD offered a signal to place a trade to the downside, yet to our dismay price rebounded.

 

As a side note, the downward move will likely still happen, it’ll just be a few weeks later than expected. However, a few weeks can be the difference between making and losing money. Which is why I never trust just one indicator. I trust price and let the indicators help confirm my assumption.

 

Crossover Method

 

I won’t get to wordy about the crossover method. It’s exactly as it sounds. When the MA line crosses above the signal line the stock is in an uptrend. When it crosses below the signal line the asset is in a downtrend.

 

But wait you say… that’s exactly what’s used in the divergence method?

 

Yes it is, the divergence method, in my opinion, is an early warning system for price reversal. And a pretty reliable one I might add.

 

The crossover is meant to be a point of entry or exit.

 

But wait!

 

Do yourself a favor and let a confirmation day pass with the expected move before entering.

 

The crossover can and will throw up a head fake as Delta so kindly shows us on 3/6 in the image above! While head fakes may be good on the basketball court, they’re of no good use to our trading efforts.

 

Overbought/Oversold Method

 

This one is just as easy as the crossover method.

 

When the faster MA line pulls away from the slower (signal line) the market is overbought or oversold. If the gap between these two lines happens above the zero line it’s said to be overbought. Below the zero line its oversold. That’s all.

 

Admittedly, I don’t love this method for determining overbought and oversold conditions but it exists and you should be aware of it.

 

Well…

 

That’s all there is to it. I think we can all agree the MacD indicator sheds a great deal of light, and very quickly.

 

In my experience, no other indicator is as powerful or more widely accepted and I certainly support a thorough understanding of everything the MacD indicator has to offer.

 

Still not convinced? Ask me in the comment section below.

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