Tips on Technicals - MACD (Moving Average Convergence Divergence)
| Indicator type: |
Momentum oscillator |
| Used to: |
Identify overbought and oversold conditions |
| Markets: |
All cash and futures, not options |
| Works Best: |
Wide-swinging trading ranges and at the conclusion of strong trends. |
| Formula: |
The Moving Average Convergence-Divergence (MACD) indicator makes use of three moving averages, usually of the exponential variety. Two are averages of price and the third is an average of the difference of the other two.
The MACD line is generated from the first two averages, subtracting the longer from the shorter. This is the same calculation as in departure charts. The Signal Line is simply a moving average of the MACD line.
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| Parameters: |
Common moving average sets are {26,12, 9} and {17, 8, 9}. Exponential averages are usually used. As with all moving average based analyses, the longer the average, the longer the analysis horizon. |
| Theory: |
In an upward and smoothly trending market, a longer average will be increasing. A short average, being more sensitive to normal price fluctuations within the trend, will show more changes in direction. If the two averages are plotted together, the shorter average will oscillate around the longer average. A strong near-term rally will cause the difference between the two moving averages to increase until some extreme value is reached. This signals an overbought condition. Conversely, in a down market, departures will become negative until an extreme is reached indicating an oversold condition. Crossovers with the average of the difference between the first two averages add another dimension to the analysis. |
| Interpretation: |
As a rule, the market is bullish if the MACD line is rising and is above the Signal Line. It is bearish if the MACD line is falling and is below the Signal Line. Buy signals are given when the MACD crosses above the signal. Sell signals are given when the MACD crosses below the signal.
Other analysis includes divergence with price action. Extreme values of the MACD line also reveal overbought and oversold conditions.
Further analysis can be made by charting the difference between the MACD and Signal Lines. This is called the MACD Histogram and it is the same as plotting the departure (oscillator) of the two lines. It then becomes easy to detect extreme ranges of departure as well as when the two lines cross.
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Figure 1 shows one year of daily data for CSCE December Cocoa futures. The divergence during the summer of 1994 is clear and the market broke its uptrend line by the end of third quarter.
The Cocoa market was relatively volatile during its divergent period. Buying and selling points were indicated throughout the chart when the Signal Line crossed above and below the MACD line. Just like with moving averages and departure charts, this crossover indicates a possible entry point. Note that crossovers should occur at overbought or oversold levels of MACD. Since MACD is not indexed (like RSI or Stochastics), the definitions of overbought and oversold are market specific.
Figure 2 shows one year of daily data for Knight-Ridder stock. Each trend break in MACD preceded the trend break in prices by several days. As can be seen in the July 1994 break, MACD gave a short-term signal that the bar chart did not. Keep in mind that trend breaks in MACD are warnings of possible trend breaks in price and not actual trading signals.
