The MACD stands for Moving Average Convergence-Divergence and is one of our favourite momentum oscillators and is useful in highlighting breakouts, strong trends and potential reversals. The MACD is calculated by subtracting one longer time framed moving average from a shorter-term moving average. The signal line is then a moving average of that calculation.
MACD = (12-day EMA - 26-day EMA)
Signal Line = 9-day EMA of MACD
EMA is the exponential moving average
Standard MACD is the 12-day Exponential Moving Average (EMA) minus the 26-day EMA. Closing prices are used for these moving averages. A 9-day EMA of MACD is plotted with the indicator to act as a signal line and identify turns.
BUY and SELL Signals
Buy and sell signals are generated when the MACD and Signal line cross. When the MACD crosses up through the signal line from below it is a BUY signal. When the MACD cross down through the signal line from above it generates a SELL signal.
The chart below of sugar display some very clear MACD signals. The low point in 2010 was highlighted by a turnaround in the MACD as it crossed through its signal line. If we were to compare where the MACD signal gave its BUY signal to just using a basic moving average crossover system of (12 and 26 EMA) it is vastly different. Because the MACD measure the difference between the 12 and 26 EMAs, the crossover point for the moving averages is obviously when the MACD crosses the zero (or horizontal line). We can see in the chart below that the MACD buy signal came two months before the moving average crossover system did.
The same happened in reverse at the peak of sugar prices where SELL signals were generated as the MACD crossed down through the signal line in early 2011, just before sugar prices plummeted.
Divergence and Trendline Breaks
Like the RSI, both positive and negative divergence can give signals that trend is drawing to a close and a reversal is likely soon.
Positive divergence occurs when during a downtrend physical prices register a new low but the MACD fails to do so instead making a higher low. This is suggests that while prices have continued to move lower are they are doing so with less intensity and aggressive, in other words, the strength in this selling pressure is weakening. Again it will not take much buying interest to see prices reverse.
Negative Divergence works in reverse, during an uptrend prices make a new high point but the MACD fails to do so, instead making a lower low or series of lower lows – effectively, heading in the opposite direction.
Below in the chart of the German DAX index we show cases of both positive and negative divergence. Positive divergence first - looking at the 2009 low the DAX made a new low while the low in the MACD that it coincided with was higher than the low the MACD made in late 2008. This suggested that the momentum in this downtrend was losing strength and a reversal was probable.
Negative divergence can be seen at the peak in in late 2007 where new highs in the DAX were not mirrored by the MACD. Instead the MACD has already begun to drift lower from its mid-year high levels. Negative divergence has also made an appearance again in early 2011 where new highs in the DAX have been met with the MACD failing to make new highs itself. Again signs that the bullish uptrend is failing and selling pressure is likely to have a more substantial effect on prices than at any other time in the rally.
Trendline breaks can also be used to signal price reversals before they occur on the physical chart. An example of how this is used is show below using the same DAX chart as earlier. The trendline on the MACD stretches for almost two-years duration and following some positive divergence broke this trendline to signal a trend reversal and a recovery in the DAX which was seen.
Comparing this to the trendline break on the physical DAX chart, the MACD signal is many weeks before giving early signs that the DAX was poised for a major rally. By combining divergence with trendline break plus crossover BUY and SELL signals as discussed, the MACD is extremely useful in identifying turning points in markets. Most importantly it’s the major turning points that it identifies.