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Trading The Moving Average Convergence Divergence

11/20/14 06:00:15 PM
by Stella Osoba, CMT

The moving average convergence divergence (MACD) is a popular indicator found on just about all software trading packages. Even though it is widely used, sometimes it is useful to return to basics, to ensure that we master the core principles to effectively use this popular technical tool in our trading.

Security:   NOV
Position:   N/A

The MACD is composed of two lines; an MACD line and a signal line. Three exponential moving averages are used in its construction. A moving average is a calculation of the average price of a set number of days to smooth out the noise in a time series. An exponential moving average (EMA) is a moving average which is calculated by giving more weight to the current price and less to older price. Standard parameters for the MACD are 12, 26 and nine. This means that an EMA for a 12-day time series is calculated as is an EMA for a 26 day times series. To get the first of the MACD lines, you take the difference of the 26 EMA and the 12 EMA, and plot the resulting value as a time series. To derive the second line called the signal line, you smooth the MACD line (which you have derived from the difference of the 26-day EMA and 12-day EMA to create a time series) by a nine-period EMA. The MACD is the faster line and the signal line is the slower line. The MACD is usually plotted on a separate box below the price chart. See the chart of National Oilwell Varco, Inc., (NOV) in Figure 1. The MACD line is black and the signal line is red.

Figure 1. Applying The MACD. On this chart you see four main uses of hte MACD in generating trading signals. They are divergence in price and the indicator, crossing of the zero line, moving into overbought/oversold conditions, and crossing of the MACD and signal lines.
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There are four main uses of the MACD in generating trading signals.

* Divergence in price and the MACD
* Crossing the zero line
* Passing into overbought or oversold conditions.
* Crossing of the MACD and signal lines

Divergence in price and the MACD: Before I discuss what constitutes a divergence, it is pertinent to remember that trading signals must always come from price action. Any indicator is only to be used to confirm signals given off on the price chart itself. Divergence, which can be positive or negative, is a signal worth paying attention to. When price trends higher but the MACD does not, it might be a warning of a possible top in prices. In the chart in Figure 1, the lines at (1) show a negative divergence. A positive divergence is when the MACD line is well below the zero line in oversold territory and starts to move up while price remains lower. This is an early sign of the reverse or a possible bottom in price.

Crossing the zero line: Because the MACD fluctuates above and below a zero line, this crossing can also be useful as a signal to pay attention to. A crossing below the zero line as in (2) would be a signal to sell while a crossing above the zero line could constitute a signal to buy.

Overbought and oversold conditions: As I already mentioned, the MACD is constructed around a zero line which cuts through the middle of the chart. The values below and above are negative and positive. When the MACD goes too far in either direction, it is said to be overbought or oversold, depending on if it is in the positive or negative zone. In the chart of NOV, you see that at (3) it was oversold. But in and of itself, this would not constitute a trading signal; it would only serve as a signal to pay close attention to price for confirmation of an entry signal like a crossing of price over a moving average.

Crossing of the MACD and signal lines: When the two MACD lines cross, this can constitute a buy or sell signal. If the MACD line (faster) crosses above the signal line (slower), this can constitute a buy signal, while a crossing of the MACD below the signal line can constitute a sell signal. The danger here is in the possibility of getting whipsawed as crossovers can create far too many false signals. It is worth repeating again that it is often best to wait for price to give a signal to confirm before entry into a trade.

Sometimes a cluster of signals will appear close together, so for instance, you will have a negative divergence, warning of a top, and then as price turns down a crossing of the MACD below the signal line and then a crossing below the zero line. The more signals you find in a particular price area, the more evidence that a significant reversal is likely.

Stella Osoba, CMT

Stella Osoba is a trader and financial writer. She is a frequent contributor to "Technical Analysis of Stocks and Commodities" magazine and " Advantage" as well as other financial publications.

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