Using MACD indicators to Identify Trend Changes


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The MACD indicators form a critical part of the Technical analysts tool set.This article describes how MACD indicators could be used to find out the trend changes in stock prices or indices.

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Using MACD indicators to Identify Trend Changes

  1. 1. Technical Essentials: Using MACD Indicators to identify trend changes Tuesday, 07 April 2009    Page 1   
  2. 2.     Introducing the MACD Indicator The (MACD) Indicator is a technical analysis method first developed in the 1960s by Gerald Appel, a prominent author in investment and trading strategy. MACD stands for Moving Average Convergence-Divergence and is based on the comparison of fast and slow exponential moving average prices. Proponents of MACD Indicator methodology argue it can be used to identify trend changes in stocks and indices and therefore can inform trading decisions. However, recent research has suggested that trading solely on the back of these signals has a tendency to result in loss making strategies and the methodologies described below are now most commonly used as part of a more complex strategy or as a monitoring tool rather than a primary trading strategy. How it works The first step in deriving MACD Indicators is to plot a slow and a fast exponential moving average (EMA) of closing prices. The standard method is to use 12 and 26 day periods. The shorter 12 day EMA gives more weight to recent prices than the longer 26 day measure. The next step is to calculate and plot the difference between the two exponential moving averages; MACD = EMA (12) – EMA (26) A subsequent smoothing is applied by calculating and plotting a Signal line. This is done by taking a further exponential moving average of the MACD line. The standard is to use a 9 period EMA. Therefore; Signal line = EMA (9) of MACD. The final step is to calculate the difference between the MACD line and the Signal Line. The standard representation is to plot the MACD and signal lines on top of a histogram which represents the difference between the two. In the example chart below the top section shows the actual prices Tuesday, 07 April 2009    Page 2   
  3. 3.     with the 12 and 26 period EMA lines superimposed. The lower portion shows the MACD line (red), Signal Line (blue) and the difference between them (histogram) Basic trading signals - MACD line crossing zero Because the MACD line is created from the 12-period and 26-period EMA lines, when the MACD line crosses zero from below, the shorter-term 12-period EMA simultaneously crosses the 26-period EMA from below. As the shorter 12-period EMA gives more weight to recent prices, when it crosses the 26 period EMA from below it indicates recent prices have trended higher than less recent ones, this is seen as a bullish signal. When the 12 period EMA crosses the 26 period EMA from above, the MACD line will cross zero from above. This indicates that recent prices have trended downwards and is seen as a bearish signal. If we apply these signals to the 6 month Nifty chart below we see the following; Tuesday, 07 April 2009    Page 3   
  4. 4.     It could be argued that the trading signal identified a bullish trend starting in the 2nd half of March and a bearish one starting in the 2nd half of May. However it is clear that the trends were identified long after they had begun. In this example the MACD line cross-over trading signal resulted in a small loss because the trader would have got into the bull and out of the bear too late. Tuesday, 07 April 2009    Page 4   
  5. 5.     MACD Crossing Signal line An alternative MACD Indicator is the MACD crossing Signal Line. Using this method a buy signal is generated when the MACD line (red) crosses the MACD Signal Line (blue) from below. Similarly, when the MACD line crosses the Signal Line from above, a sell signal is generated. Looking at the same six month Nifty chart we see the following; Clearly this method identified the same trends as the MACD line crossing zero method. However, this time the trading signals are generated earlier and resulted in a profit whereas the MACD line crossing zero trading signals resulted in a loss. Tuesday, 07 April 2009    Page 5   
  6. 6.     MACD Divergence and convergence The previous two sets of trading signals used the MACD and Signal Lines. The third common MACD indicator relies on the histogram. By looking at the solid bars of the histogram it is easy to identify two scenarios. Convergence describes the situation where the histogram is shrinking because the MACD is getting closer to the signal line. Divergence is when the histogram is growing and the MACD is moving away from the Signal line. If the MACD histogram is increasing in size (divergence) then difference between the MACD and Signal lines is increasing. This implies that the underlying stock or index is moving strongly in one direction. Similarly when the MACD histogram is decreasing in size (convergence) the difference between the MACD and Signal Line is decreasing. This often implies that the previously strong trend in the underlying stock or index is weakening or possibly reversing. Tuesday, 07 April 2009    Page 6   
  7. 7.     MACD convergence trading signals When the MACD histogram is below zero and converges towards zero, this implies the strong downward trend of the underlying stock or index is weakening or possibly reversing. This is seen as a bullish signal. When the MACD histogram is above zero and begins to converge towards zero, this implies that the strong upward trend of the underlying stock or index is weakening or reversing. This is seen as a bearish signal. Applying this method to the same 6 month Nifty chart we see the following; In four out of the five situations the MACD indicator was close to identifying the top / bottom of the trend in the underlying index. However the convergence in July proved to be a false signal because although the MACD histogram converged towards zero it only crossed it momentarily and the downward trend of the underlying index continued. This is an example of the MACD indicator identifying a temporary weakening in the trend rather than a fundamental reversal. Clearly buying here and then selling on the next sell signal would have resulted in a small loss. Tuesday, 07 April 2009    Page 7   
  8. 8.     MACD Health warning The 6 month Nifty period used in this article was chosen based on the fact that it contained examples of the 3 types of MACD Indicator and not because the Indicators performed well or badly in this period. As mentioned in the introduction, trading solely on the basis of MACD indicators has been shown to result in more losing trades than winning ones. Because the technique is based on 12 and 26 day exponential moving averages, it is a lagging indicator and often identifies trends too late for the trader to profit from them. It also often fails to correctly identify trend changes in volatile market conditions or for volatile assets. It does however remain a useful monitoring tool for the technical analyst and can inform trading decisions when the MACD signals are confirmed (supported) by other forms of technical analysis. Tuesday, 07 April 2009    Page 8