Trading Basics – MACD (Convergence/Divergence) – Part 1

05/08/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

No discussion of momentum-based indicators would be complete without a discussion of the MACD or Convergence/Divergence, developed in the late 1970s by Gerald Appel. Speaking at my first technical analysis seminar in 1983, I discussed my early research and modifications of the MACD. It was not widely used at that time, and I demonstrated how it could be used not only on the stock market (the original intention) but also applied to commodities, mutual funds, and individual stocks. Over 20 years later it is now probably one of the most widely used indicators and is the default indicator on many free sites.

In previous articles we have discussed other price-based or momentum indicators such as the RSI, but the MACD can give the trader additional information. What is the MACD? It is essentially a complex, triple moving average system. First, the MACD is calculated by taking the difference or spread between a 26- and 12-period exponential moving average; then, the signal line, which is a nine-period exponential moving average of this difference, is calculated. In past issues we have discussed using weighted moving averages. Exponential moving averages are just one type of weighted average where the most recent data is given more weight using an exponential formula.

The most basic interpretation is that when the MACD is above the signal line, it is giving a positive signal; conversely, when it is below the signal line, it is negative. Traditionally, these were plotted as two lines, but I found that by plotting the difference as a histogram, which I called the MACD-His, positive and negative divergences were revealed. In summary, whenever the MACD crosses the signal line, the MACD-His crosses the zero line. Sharp increases in the MACD-His reflect a dramatic rise in upward momentum while sharp declines reflect that selling pressure has increased.

Figure 1

Since the MACD was originally designed as a stock market indicator, the first chart is the weekly chart of the Dow Jones Industrials from May 2002 through May 2004. On the bottom part of the chart you will see the MACD (black line) and the signal line (red line). I have placed blue arrows to indicate the signals. For example, at the beginning of the chart (in late April) the MACD dropped below the signal line and generated a negative signal. The MACD stayed below the signal line until October, when it started turning up and moved above the zero line. Five other signals are also noted on the chart; however, I think if you compare this plot with the MACD-His, you can see for yourself why I find it more valuable.

Figure 2

The MACD-His first dropped below the zero line in April (point 1) and then started to decline more sharply five weeks later, consistent with an increase in selling pressure. It reached its low point in July and then started to turn higher. Even though the Dow made new lows in October (line 2) the MACD-His was higher, forming a bullish divergence (line 3). Divergences between the MACD-His and prices are the primary method of anticipating crossovers.

The histogram did lose momentum early the next year, dropping below the zero line for six weeks (circle 4) before moving back into positive territory. The MACD-His remained positive until November when once again it briefly violated the zero line (circle 5), but after just three weeks moved back above the zero line. Even though the Dow was over 1,000 points higher in early 2004, the MACD-His formed a bearish divergence (line 6). This warned that a change in trend was likely and the MACD-His soon dropped back below the zero line.

I have found that the MACD-His is most reliable with monthly or weekly data, but it can also be successfully used when the weekly and daily analysis are combined. The first step is to look for weekly divergences, such as that which was observed in the fall of 2002 (Fig. 2, line 3). Then one would go to the daily chart (Fig. 3) and look for corresponding divergences. In early October, the daily MACD-His formed a series of higher lows, (line 1), and then moved above the zero line on October 11, which was a positive signal. The weekly MACD-His then turned positive on October 25, as indicated by the green vertical line, labeled A. With the weekly MACD-His positive, only those daily signals in agreement with the weekly trend are taken. However, if divergences start to form in the weekly trend and they are confirmed by the daily MACD-His, you should be attentive to an overall change in the market’s direction.

Figure 3

Therefore, the negative daily signals in both November and December would have been a reason to sell longs but not to establish short positions. By late December, the daily MACD-His (line 2) had formed three-month negative divergences suggesting that the trend might be changing. However, no divergences were evident in the weekly MACD-His. The daily MACD-His turned negative on January 21, and then began to drop sharply. By February 7 the weekly MACD-His had also turned negative as indicated by the red vertical line, labeled B.

Because of the strong positive divergence at the October lows, and without the formation of new weekly divergences, these negative signals were consistent with a correction, not a major new decline. The daily MACD-His formed another positive divergence in March, (line 3), and then rose sharply, quickly surpassing the previous peaks. This was an indication of strong upward momentum. The weekly MACD-His was soon also back above the zero line and it would be almost a year before any weekly negative divergences were evident.

As I mentioned earlier, though the MACD-His can be a bit choppy on the daily and even more so on the intra-day data, longer term analysis is where it can shine. The final chart features the Nikkei 225, which does not follow our stock market that closely. The monthly chart of the NK 225 shows a series of positive divergences (points 2 and 3) as the NK 225 was dropping below the 8000 level. You will recall that it had peaked above 39000 in 1989. These positive divergences were confirmed when the monthly MACD-His turned positive at the end of May 2003. This also corresponded with the breaking of the long-term monthly downtrend (line 4). The index has doubled from the lows and the monthly MACD-His has stayed positive throughout this period.

Figure 4

During the years of teaching traders about the MACD-His, I have found that some find it quite useful and comfortable for them to use, while others have the opposite viewpoint. Personally, I have found it the most useful when used in conjunction with an indicator that uses volume such as the demand index or the OBV. The only way to determine whether the MACD-His might be a useful tool for you is to start applying it to the markets that you trade. Be sure to look at least two, and preferably three, different time periods, as in my view it requires multiple time frames to smooth out the signals.

As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow''s MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."