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Stocks & Commodities V. 19:12 (83-85, 93): Working Money: A Taste Of The Big MACD by Amy Wu

A Taste Of The Big

Indicators like the moving average convergence/
divergence help you confirm signals and decrease
risk when buying and selling securities. Invented by
Gerald Appel in the 1970s, the MACD has become a
staple in the world of technical analysis. Here’s how
you can make use of it.

by Amy Wu

O ne of the most popular indicators used in techni-

cal analysis is the MACD (moving average con-
vergence/divergence). In its most common form, the MACD
mean (or average) of a series of prices over a period of time.
The exponential moving average is a weighted average; re-
cent prices count more than previous prices. To calculate an
is calculated by taking the difference between a 26-day and exponential moving average, you apply a chosen percent-
a 12-day exponential moving average. This difference, some- age of today’s close to yesterday’s moving average. Sup-
times referred to as the price oscillator, will vary depending pose you wanted a 9% exponential moving average; 9% is
on the momentum of the security. A second line, called the the chosen weight you’ve assigned to the more recent price.
signal or trigger line, is created by taking a nine-day expo- You would multiply the security’s close by 9% and add this
nential moving average of the price oscillator. to 91% multiplied by yesterday’s moving average (100%-
The MACD is a trend-following indicator, moving in the 9%=91%):
direction of the prevailing price movement. This should be
apparent, since it is based on moving averages that are cal- [Today’s close * 0.9] + [yesterday’s moving average * 0.91]
culated by using a security’s price history. Since the price
oscillator is the 12-day minus the 26-day exponential mov- As you may have noticed, the MACD uses days instead of
ing average, a difference of zero results in a horizontal line. percentages in its moving averages. This is just a convention
Such a line indicates that the 26-day and the 12-day moving used by investors, since days are more familiar as a variable.
averages are changing at the same rate. In general, the quan- Use this equation to convert percentages to time periods:
tity of the difference and whether it is positive or negative
show how much faster or slower the exponential averages Time periods = (2/percentage)-1
are moving relative to each other.
Using the 9% example, this would give you [2/(0.09)] - 1,
EXPONENTIAL MOVING AVERAGES which equals 21.2 days. When the result is a decimal (for
The exponential moving average is a variation of the mov- example, 21.2 days), round it to the nearest whole num-
ing average. A simple moving average is just the arithmetic ber (21 days). Because simple moving averages assign

Copyright (c) Technical Analysis Inc.

 Stocks & Commodities V. 19:12 (83-85, 93): Working Money: A Taste Of The Big MACD by Amy Wu
QQQ – Daily AMEX C=39.45 –0.70 –1.74% 0=40.14
120.00

115.00

110.00

105.00

100.00

95.00

90.00

85.00

80.00
Divergence
75.00

70.00

65.00

60.00

–1.06 –.083 –0.22 0.00 4.00

2.00

TRADESTATION (TRADESTATION GROUP)

0.00

-2.00

-4.00

A S O N D OO F M A M J J A S O

FIGURE 1: THE MACD WORKS WELL IN UPTRENDS. At the end of October 1999, the MACD lines went above the zero line and stayed above it until the
QQQ (Nasdaq tracking index) plummeted.

equal weighting, the number of days and the number of its signal line, the 26-day exponential moving average is
averages will be equal. But if you weight days differently, it growing larger relative to the 12-day exponential moving
is like giving some moving averages more days — and oth- average.
ers fewer days. Since the exponential moving average is a As the difference of the price oscillator decreases, it sug-
function of weight as opposed to days, the EMA days are not gests that the strength of a trend is waning. Buy/sell sig-
the same as those of the simple moving average. This calcu- nals can also be generated using the zero line. When the
lation will give you a rough estimate of how many days the price oscillator goes above or below this line,
EMA comprises, depending on the percentage. you get a buy or sell signal, respectively.

INTERPRETATION OF THE MACD Overbought/oversold

Now that you know what the MACD is conditions:
and how to calculate it, you’re prob- Overbought and oversold conditions occur when prices have
ably wondering what it does. There are moved too far and too fast in either direction. This speed makes
three major ways to use the MACD: them vulnerable to reactions, such as corrections in the mar-
identifying crossovers, finding over- ket. The MACD attempts to define the points where a security
bought/oversold conditions, and track- becomes overbought or oversold. For instance, when the
ing divergences. shorter-term EMA diverges significantly from the longer-term
EMA (in this case, the difference would be getting quite large;
Crossovers: When the price os- the MACD would be rising), it may be because the price of the
cillator falls below its signal line, the security is overextended and will soon return to more normal
point of intersection is a crossover. These points are usu- levels. By using the buy/sell conditions, you can decide whether
ally an indication to sell. Likewise, when the price oscil- the MACD is showing a security as overbought or oversold.
lator rises above its signal line, this point of intersection
shows a buy signal. These signals are fairly intuitive be- Divergences: Whereas convergences would move two
cause they are derived from the momentum of relative related things closer together, divergences move them away
moving averages. If the price oscillator is falling below from each other. When the MACD lines move in the opposite

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 19:12 (83-85, 93): Working Money: A Taste Of The Big MACD by Amy Wu

direction from the security price, it could mean that a cur- and so forth. Also like most indicators, the MACD can fail
rent trend is at its end. A bearish divergence occurs when the you at times. It is always best to cross-reference indicators
MACD hits new lows but the prices do not hit new lows. A with others, or to use indicators as a confirmation (as op-
bullish divergence happens when the MACD hits new highs posed to as the entire rationale for a decision). Sometimes
but the prices do not hit new highs. These divergences are using indicators based on different measures can be help-
most significant when they occur when the MACD is at over- ful. If you get mutual confirmation from indicators that rely
bought/oversold points. on different properties, you can drastically reduce your risk.
In addition to the default 26- and 12-day MACD, other
USING THE MACD MACDs exist that take into account specific securities. Good
The MACD works well in trends and for long† positions. It luck and happy investing!
has shown good results when used on securities that tend to
have longer-term trends, such as the currency commodity Amy Wu is a student at Princeton University, majoring in
markets. When divergences occur within a trend, the MACD economics and financial engineering.
is less effective. One of the drawbacks of the MACD is that it
can cause whipsaws† because it tends to follow price move- SUGGESTED READING
ment even on rapid ups and downs. Appel, Gerald [1985]. The Moving Average Convergence-
The MACD is depicted in two ways — a line version and a Divergence Trading Method, Advanced Version,
histogram version. In the line version, the price oscillator Scientific Investment Systems.
and signal are displayed as a line. On the histogram, the dif- Gopalakrishnan, Jayanthi [1999]. “Trading The MACD,”
ference between the MACD and the signal is displayed as Technical Analysis of STOCKS & COMMODITIES, Volume
vertical bars, above or below the zero line. The MACD is found 17: October.
on most technical analysis software, in both the line and his- Star, Barbara, Ph.D. [1994]. “The MACD Momentum
togram versions. Oscillator,” Technical Analysis of STOCKS & COMMODITIES,
Volume 12: February.
SUMMARY
Like most indicators, the MACD is based on a few simple Current and past articles from Working Money, The Investors’
measurements: momentum, moving averages, divergences, Magazine, can be found at Working-Money.com.

Copyright (c) Technical Analysis Inc.

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