Moving Average Convergence/Divergence (MACD)

One of the more widely used indicators used by “technical traders” is the Moving Average Convergence/Divergence (MACD). For the theorists, it is simply the difference between two exponential moving averages with different periods.

The most widely used time periods for the MACD is 26 days for the slow moving line and 12 days for the fast moving line. These lagging indicators subtracted from one another resulting in a momentum indicator called an oscillator.

There is no need to understand the theory as the practical use of the oscillator is visual: it swings back and forth over a “zero line” signaling both buy and sell actions.

In order to use the MACD buy and sell signals successfully, the trader should apply the MACD oscillator when the share price trend is changing. That is, the trader needs to observe a flattening or reversal in the current share price trend in tandem with the shorter-term faster-moving line of the indicator crossing over the longer-term slower-moving line.

When the MACD direction diverges from the share direction, the combination indicates that an end to the current trend may be near. A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows. A bullish divergence occurs when the MACD is making new highs while prices fail to reach new highs.

Both of these divergences are most significant when they occur at relatively overbought/oversold levels.

Importantly, when bearish or bullish divergence occurs, the change in the underlying security is normally dramatic. This means it can be converted into big dollars for the trader.

EXAMPLE:

On the above daily chart of the National Australia Bank (NAB) from May to October 2005, the crossover of the MACD has occurred before or around the same time as the change in the short-term shape price trend. In the first instance, the bearish engulfing red candle in June was not confirmed by the following day’s candle, however the MACD was suggesting otherwise. The short-term counter trend continued until the faster moving average (12 day) crossed over the slower moving average (26 day) in July. Like all indicators, they are NOT fool proof so it is mandatory to carry out other supportive analysis.