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MACD

Subject: MACD (Moving Average Convergence/Divergence)
Written by: Mystifier
June 4th,1999

Definition of Price

Before any read of the chart can be done one must have an idea of what "price" is. I will rely on what what Dr. Alexander Elder has stated in his book "Trading for a Living". Dr. Elder states, "Price" is a momentary consensus of value between all market participants at the time of transaction." In other words what any trader/investor is willing to buy or sell the stock for at any given time.

Now because price is represented in numerical form its patterns, or the wavy line it makes on the chart, can be mathematically analyzed. This is what is known as technical analysis, TA for short. The tools used for TA are called technical indicators. There are many different kinds of TA indicators ranging from simple "moving averages" to the more esoteric "fractal polarization" indicator.

MACD (Moving Average Convergence/Divergence)

I will start with the indicator that Dr. Elder describes as capable of giving "the most powerful signal in TA", the MACD indicator. MACD stands for "moving average convergence divergence." A moving average represents the mass consensus of traders/investors over a certain time period. A long moving average tracks the long term consensus, and a short MA (moving average) tracks short term consensus. The fast MACD line reflects mass consensus over a shorter period. The slow Signal line reflects mass consensus over a longer period. When the fast MACD line rises above the slow signal line, it shows the bulls are in control and its better to go long than short. When the fast line falls below the slow line, it shows the bears dominate the stock and its better to go short.

The MACD Histogram gives you a better picture of what's going on. It not only shows you whether the bulls or the bears are in control but also whether or not they are growing stronger or weaker. Below is a picture of the MACD histogram on the Nasdaq Composite Index:

The MACD histogram = MACD line - Signal line

The MACD histogram measures the difference between the MACD line and the Signal line, and plots the difference as a series of vertical bars. If the fast line is above the slow line, the MACD histo is positive and plotted above the zero line. If the fast line is below the slow line the histo is negative and plotted below the zero line. When the 2 lines touch, the MACD histogram = zero.

When the spread between the 2 lines increases the bars become taller or deeper, depending on its direction. When the 2 lines get closer together the bars become shorter.

Trading Rules

- Buy when the MACD histogram stops falling and ticks up. Set a protective stop below the latest minor low.

- Sell short when the MACD histogram stops rising and ticks down. Place a protective stop above the latest minor high.

MACD Histogram Divergence

Regarded by Dr. Elder as the strongest signal in technical analysis! These divergences identify major turning points and give "extra-strength" buy or sell signals. No technical indicator is 100% accurate at all times but this signal ranks high on the % list. Here is how to identify this signal. You can refer to the graph above. A bullish divergence occurs when price has reached or exceeded a new low but the MACD histogram traces a more shallow low. It's a tell that the bears are weaker than they seem and the bulls are ready to take control. It's safe to go long but place a protective stop below the latest low. A bearish divergence occurs when prices have rallied to new highs but the MACD histogram traces a lower peak than the previous peak. It's safe to go short but place a protective stop above the latest minor high.

Note on the above chart the bullish divergence that correctly pointed out the rally in early '98. In late '97 price was decreasing but the macd histogram was tracing a shallower bottom (ie: the bars below the zero line were getting shorter). Notice also the bearish divergence that occured in mid '98. See how the trend in price kept getting higher but the macd histogram bars became much shorter toward the end of the price uptrend?

One more thing about the MACD Histogram.............it works in any timeframe: weekly, daily, and intraday. The greater the timeframe the greater the price move.

Mystifier
Copyright June 1, 1999

Revised August 7th, 1999

Revised October 31st, 1999

Below I have provided the book that I believe offers the best information on Technical Analysis trading that I have had the pleasure of reading. If the subject interests you I give it my strongest recommendation. The companion study guide is extremely useful also. I was amazed at how many questions I answered incorrectly the first time through! Now I only get half of them wrong.......hehe! Enjoy! ~ Myst~

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