The MACD (Moving Average Convergence Divergence) is a valuable indicator, with many interesting aspects. In this article we will show how it is constructed and how it can identify a trend reversal, enabling the investor to buy and sell more profitably (and also more frequently) than with the two-moving-averages method.
In Chart 1 we see two moving averages: a short one of seven sessions (EMA7) and a longer one of 27 sessions (EMA27). The short average is always very close to the price of the stock and it moves almost at the same time as the price, while the long average is, logically, slower to react. We know that when the two averages cross we have a signal: a buy signal when the EMA7 crosses above the EMA27 (Buy signal in Chart 1); a sell signal when the EMA7 crosses below the EMA27 (Sell signal in Chart 1). The chart shows many of these signals, but I have only indicated two, for illustration purposesfootnotes 1.
Diagram 1 shows the crossing-averages method.
The advantage of using the crossing-averages method is that you can buy and sell a stock when a new trend has already started. So it is the most conservative and safest method. However, looking at Chart 1, we also see the drawback of this method: the signal sometimes occurs far from the beginning of the trend. For example, we see that the buy signal is at approximately $102, when the most recent low associated with this signal is at about $96: loss of a potential profit of $6. And the sell signal is at $123, when the closest high is $132: loss of a potential profit of $9.
These lost opportunities are tolerable here when we consider that the investor still bought at $102 and sold at $123, a gain of $21 on an investment of $102 in less than two months. Nevertheless, it's always preferable to buy at a lower price and sell at a higher price, if the trend offers this opportunity. The method that most often allows an investor to realize this opportunity is called the MACD (Moving Average Convergence Divergence). This indicator is based on the following observation:
When the distance between the EMA7 and the EMA27 increases, the price trend is solid and continues in the same direction. When the distance between the EMA7 and the EMA27 decreases, the price trend is weakening, resulting in pullbacks and congestion.
This is what we see in Chart 1: after the EMA7 and 27 cross to give the buy signal shown, the distance between the two averages increases because it is a strong uptrend. Then the price stops rising, creating congestion between $122 and $132. We then see the two averages approach each other, and they end up crossing and giving a sell signal.
To show more clearly the principles just described, we can use the technique illustrated in Diagram 2.
In Diagram 2, we show the EMA27, but this time it is a horizontal line. Moving around it is the EMA7. What we have done is “extract” the EMA 27 from Chart 1 to make it a horizontal line. We then “extracted” the EMA7 from Chart 1 and placed it around the EMA27: the points where the EMA7 crosses below the EMA27 are sell signals, as in Chart 1. The points where the EMA7 crosses above the EMA27 are buy signals, as in Chart 1. Diagram 1 is thus a different way to show the series of signals given by the EMA7 and the EMA27. We will now move on to Diagram 3, where we can start to see what the MACD can offer us.
Here we see the ABC cycle: the difference between the EMA 7 increases (A), then it stabilizes (B) and, finally, it decreases (C). What is important to note is that when we go from phase B to phase C, the price is at a high or a low. The MACD indicator will signal when phase B becomes phase C. To get these signals, we create a third EMA: an average of the series of differences between the EMA7 and the EMA27. This average is in Chart 2 an EMA7 and we call it the MACD. We then get the following rules illustrated in Diagram 4:
Chart 2 shows only some of the signals offered by the MACD. The reader should have no difficulty identifying other signals in the same chart. What should be noted is that the MACD gives more frequent signals than the EMA method, because it indicates not only major trend turning points, but also minor turning points in the same major trend.
The MACD has many other interesting facets to explore, which will be the subject of an upcoming article on this indicator.
- EMA stands for Exponential Moving Average. Its main characteristic is that it gives more importance, more weight, to the most recent price in a series, whereas the most distant price in the series is of negligible importance. For example, in a EMA27, out of 27 closes, the most recent, the 27th, counts more than the most distant, the first of the 27. This is very different from what happens when we use SMAs (Simple Moving Averages). In the latter case, each price, whether the most recent or the most distant, is of equal importance in the average. EMAs are considered more reliable than SMAs.