Section III: Moving Average Convergence-Divergence (MACD)
The MACD charts the difference between two exponential moving averages (a longer period EMA subtracted to a short period MA). The most common settings applied to MACD are 26 periods EMA and a 12 period EMA.
The MACD is positive when the EMA(12) is above the EMA(26) indicating that the rate of change of the shorter period MA is higher than the longer period MA and this indicates positive momentum. On the other hand, it is negative when the EMA(12) is below the EMA(26), the rate of change of the shorter period MA is lower than the longer period MA indicating negative momentum. These values are then plotted in a histogram.
Usage No. 1 - As an oscillator indicating overbought/oversold conditions.
An overbought condition indicates that the instrument has been bought all the way up, and a probable short term reversal is very likely to happen. An oversold condition indicates that bears have been selling an instrument all the way down at a certain point that it is very likely that buyers start taking command of prices attracted by cheap prices (short-term reversal).
Every time the MACD gets overbought or oversold the market tends to change direction. But what is considered overbought or oversold with the MACD? Good question... it is relative to the previous highs or lows as there are not “set levels” for the MACD to be considered overbought or oversold. This is one of the weak points if the MACD for this usage.
Although this MACD usage is not very common, there are still traders that use the MACD in this way.
Usage No. 2 - Centerline crossover. When the MACD crosses from negative territory to positive territory, it is called a bullish crossover and indicates positive momentum. On the other hand, when the MACD crosses from positive territory to negative territory it is called a bearish crossover ant it indicates negative momentum.
When the histogram crosses from the negative territory to the positive territory it means that the market is gaining positive momentum signaling a long trade.
Usage No 3 - Divergence trading. A divergence occurs when the price behavior differs from the indicator behavior. Theoretically, when the price reaches new highs, the indicator should also reach new highs and the opposite is also true for a bear market. Therefore, when the price makes new highs and the indicator fails to do the same, or when the indicator reaches new highs and the price fails to do the same, a divergence is present. The same is true when the indicator reaches new lows and the price fails to do so or when the price reaches new lows and the indicator fails to do the same.
The second low created by the market is clearly at lower levels than the first low. The MACD fails to make a similar low and creates a higher low instead.
This creates a divergence signaling the market isn’t as bearish as it used to be.
Combination of MACD Signals
Please take a look at the following chart and try to determine what we are using to generate the signal (yellow triangle).
In this chart we used the divergence signal coupled with the centerline crossover signal as a confirmation. Once the market created the divergence we need the MACD to cross below zero to confirm the signal. Of course we could add the support line break out also (blue horizontal line).