Real market case studies show how to properly apply the popular MACD indicator in order to generate early warning signals about changing trends in a variety of markets.

Up until 1982, when I officially changed careers, my computerized technical analysis had been accomplished by manually entering data into a spreadsheet program. I left biochemistry to become the Director of Research for a financial firm that had recently acquired computer software called CompuTrac. Many of you are likely not familiar with this software, but even then, it probably had at least 80% of the technical tools that are available on today’s software.

Tim Slater was the driving force behind the project, though ideas were contributed by a number of well-known market technicians, and the programming was done by a computer expert by the name of Jim Schmidt. Over the next 20 years, Tim organized technical analysis group (TAG) seminars around the world and was recognized for his efforts by the International Federation of Technical Analysts.

One of the early studies I found was called convergence/divergence, but is now known to most as the Moving Average Convergence/Divergence (MACD), which was created by Gerald Appel in 1979. At the time, I could not find anyone who was using this indicator.

In 1983, I was able to meet Gerry, as we were both speaking at a TAG conference, and I told him what a great indicator he had developed. He seemed pleasantly surprised at my praise for the MACD, as he had moved on to other methods of analysis.

I explained to him that I was especially impressed by the signals the MACD gave when analyzing weekly currency data, which was a market he did not follow. In the late 1980’s, I had the pleasure of giving a series of seminars in Asia with Gerry and his lovely wife Judith. Let’s take an in-depth look at the indicator Gerry created.

To many, the two lines that make up MACD suggest that a complex algorithm is involved. The two lines are referred to as the MACD and the signal line. The MACD is calculated by simply subtracting a 26-period exponential moving average (EMA) of the closing prices from a 12-period EMA. The signal line is a nine-period exponential moving average of the MACD.

In a strongly trending market, the faster 12-period EMA will be rising or falling more sharply than the 26-period EMA. Conversely, when prices are trading in a range, the difference between the two EMAs will also be range bound. Therefore, the MACD is essentially a momentum oscillator that is derived from multiple moving averages.

The most basic interpretation is to buy when the MACD line crosses above the signal line and sell when it drops below it.

Figure 1

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This monthly chart of the SPDR Gold Trust (GLD) is updated through October 18, 2011 and goes back to the beginning of 2008. During that period, the MACD only gave three signals. The MACD line moved above the signal line at the end of September 2007 (line a) and GLD closed the month at $73.51.

At the end of August 2008, the MACD dropped back below the signal line (line b) as GLD closed at $85.07. Over the next 13 months, GLD had several wide swings, dropping as low as $66 and as high as $98.99. At the end of September, with GLD closing at $98.84, the MACD line again moved above the signal line, line c.

This positive momentum signal is still in effect and there is no chance that a new signal will be generated by the end of October. Obviously, for a trader or investor, these signals are probably too slow, as between August 2008 and September 2009, there were some good trading opportunities.

For those doing mutual fund switching, the monthly analysis will catch the major trends, but it is the weekly analysis that I find to be most valuable.

As I worked more with the MACD, I began to focus on a way to anticipate the crossovers. I looked at several different approaches, and at a 1984 TAG conference, I first presented charts that represented the spread between the MACD and signal lines. Two years later, I started calling this indicator the MACD-Histogram, or MACD-His.

I had observed that when the MACD line was above the signal line and the spread was widening, it indicated a strongly uptrending market. But as the trend lost its momentum, the spread narrowed. My analysis indicated that by indentifying divergences in the MACD-His, reliable signals were generated ahead of those from the MACD.

NEXT: Using MACD on the Weekly Time Frame

Tickers Mentioned: Tickers: GLD, XLE, VLO