Discussion 13 : Trend Following With Moving Average Convergence/Divergence (MACD)

Hello and a very good day to you! 

While viewing the charts that I have included in my previous Discussions, you guys might have seen some Momentum Indicators (MI) and Momentum Oscillators (MO) being plotted to enhance the reliability of signals generated. These Western technical tools are generally used to gauge the force behind a price trend or movement, and very often, are used to generate entry and exit signals for technical traders.

MOs, such as Stochastic and RSI, are leading indicators of a price movement. Oscillators would make use of two lines to gauge an overbought and oversold region. It is generally understood that one should sell when the price is in the overbought region, and buy when it is in the oversold region.

MIs, such as Moving Averages (MAs) and MACD, are lagging indicators. They will urge you to chase the boats that you have missed! Despite the fact that MIs often give signals late, causing you a late entry to an already established trend, it is many times more reliable than MOs, which are renowned for their high frequencies of emiting False Signals.


INTRODUCTION
Moving Average Convergence/Divergence (MACD) is a Momentum Indicator created by Gerald Apple in the late 1970s, and futher improved by Thomas Aspray in 1986. MACD, pronounced as "mack-dee" by technicians around the world, appears in chartists' toolbox as a deadly trend following indicator. It generates entry and exit signals for long term trend tradings, and is also often used to enhance reliability of signals generated by Candlestick Patterns.


SETUP OF MACD
MACD indicator is generally comprised of 3 components:

1. MACD Line - 12 days EMA of stock price minus 26 days EMA of stock price.
2. Signal Line - 9 days EMA of MACD Line.
3. MACD Histogram - Difference between MACD Line and Signal Line.

Note that in MACD, EMAs are used in favour of SMAs. Exponential Moving Averages (EMA) put a higher weighting on the more recent stock price against the older ones. This is essential due to the principle that the latest stock prices would logically 'spearhead' the upcoming/existing trend.


ZERO LINE CROSSOVERS
Principles:
Buy Signal - When MACD Line crosses over Zero Line from the bottom.
Sell Signal - When MACD Line crosses over Zero Line from the top.

The zero line acts as a 'realm divider' between an uptrend and a downtrend. According to the MACD, an uptrend is confirmed when the MACD Line crosses above the Zero line (positive region), and a downtrend is confirmed when the MACD Line drops below the Zero line (negative region). Illustration (i) shows FBMKLCI daily chart of year 2008 and year 2009, with the Zero Line and MACD Line clearly separating the two trends.

Illustration (i) : FBMKLCI - MACD & Identification of Trend

MACD Line takes the difference between a faster EMA (12 days) and a slower EMA (26 days). As the differences increase, the MACD Line will sway further away from the Zero Line, be it in positive or negative regions. As the differences decrease (happens when stock prices consolidate), the MACD Line moves closer to Zero Line. A crossover happens when there is a change in polarity from negative region to positive region, and vice versa (happens when consolidation is over, i.e. consolidation breakout!). See illustration (ii).

Illustration (ii) : FBMKLCI - MACD & Consolidation Breakout Play

However, caution should be taken while implementing this strategy. A Zero Line Crossover could happen in an instant due to a sudden change of price momentum from upwards to downwards, or vice versa. In that case, the crossover is no longer due to a consolidation breakout, and chasing such trend could be dangerous, as the trend might have already been exhausted by the time it crosses the Zero Line.


MACD CROSSOVERS (SINGLE LINE CROSSOVERS)
Principles:
Buy Signal - When MACD Line crosses over Signal Line from the bottom (Bullish MACD Crossover).
Sell Signal - When MACD Line crosses over Signal Line from the top (Bearish MACD Crossover).

Signal Line is the 9 day EMA of the MACD Line. This acts to 'smoothen' and 'average out' the MACD Line. As the MACD Line crosses over the Signal Line, it means a change in momentum is under way. Buy and sell decisions based on MACD Crossovers should therefore be more profitable, compared to Zero Line Crossovers, as MACD Crossovers give an indication of a change in momentum, which is a necessary build-up to a change of polarity.

Illustration (iii) shows how KFC fares using the MACD Crossover strategy.

Illustration (iii) : KFC - MACD Crossovers

Traders should be careful when practising this approach as it tends to give quite a number of False Signals, particularly when MACD Line and Signal Line braid themselves during short term consolidations. Traders should make use of other predictive indicators such as Candlestick Patterns, as they could give an early psychological indication of a potential momentum outbreak.


MACD HISTOGRAM
The improvement made by Thomas Aspray on the MACD system is the introduction of MACD Histogram. MACD Histogram measures the difference between the MACD Line and Signal Line and present them in the form of histogram.

Principle:
Buy Signal - MACD Histogram reduces in length and formed below the Zero Line.
Sell Signal - MACD Histogram reduces in length and formed above the Zero Line.

When MACD Crossovers give a buying or selling signal, they are very often a late entry and exit signal. This is due to the lagging nature of Moving Averages (which is the heart of MACD system). Thomas Aspray then came up with an idea that entries and exits should not be based on MACD Crossovers, but should be triggered when the differences between MACD Line and Signal Line reduce. That is the earliest possible entry and exit points that would yield maximum profits.

Compare illustration (iv) with illustration (iii). Both charts represent KFC in the same exact situation. See the differences in profits if MACD Histogram is heeded ahead of MACD Crossover!

Illustration (iv) : MACD Histogram



MACD DIVERGENCE
This is by far the most powerful signal that any MI or MO can give. A divergence means that the price actions (price movements) are inconsistent with signals generated from the MI or MO. Divergences occur in MACD as well.

The general rule for divergences in any MI or MO is, the price action would ultimately follow the direction signalled by the MI or MO.

Study OSK's daily chart in illustration (v) and see for yourself!

Illustration (v) : OSK - MACD Divergence

CONCLUSION
MACD is a useful indicator for intermediate term swing traders and position traders, as trend following is the core concept of this system.

Shorter term traders such as day traders and short term swing traders may make use of this indicator to confirm the direction of the prevalent trend, on multiple time-frame charts. Scalpers may want to scalp only in a long position on 5-minute chart if the MACD on hourly chart shows upwards momentum. The risk of losing is then highly minimized.

There are many further information and knowledge that revolves around this topic, which I couldn't finish discussing even with another 10 similar articles! MACD is a system that looks simple, but contains highly sophisticated trading disciplines that could greatly enhance trading precision and winning probabilities, particularly for a long term position trader.

The best way to learn a technique is to learn it from its creator. I highly recommend these 2 books for my readers who are interested in perfecting this technique. One of them is written by Gerald Appel in 1985, entitled "The Moving Average Convergence - Divergence Trading Method (Advanced Version)". Another would be "Understanding MACD", a book he co-authored with Edward Dobson in 2008. These 2 books, together with other MACD materials, are now available at TLSBookstore.com.

So, ride the trend for the week ahead with MACD! I'll see you again next week~! = )


The Moving Average Convergence-Divergence Trading Method (Advanced Version)