MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)

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According to John Murphy, MACD is an Oscillator. MACD is calculated by subtracting the value of a 26 day (.075) exponential moving average from a 12 day (.15) exponential moving average. A 9 day exponential moving average (trigger line) is imposed on top of the above difference in a MACD chart.  

Before interpreting MACD, it is useful to understand why it is an oscillator. Standard simple examples of oscillators are momentum and rate of change. That is, in an oscillator, we consider percentage change or deviations. We do not consider the absolute price series; instead we consider some measure of change in the series. It is clear immediately that the data gets de-trended. That is why oscillators are not trend following indicators. They are useful in non-trending markets. MACD is the difference between two moving averages and hence the data has been detrended. We are looking at a spread and hence it is an oscillator.

Generally oscillators operate within a band and the value zero plays an important role. They are useful when the value of the oscillator reaches the upper band or the lower band and also when it crosses the zero line. Oscillators give better indication of the price action when the values reach the extremes and can indicate whether the market action is slowing down before actually when the price action slows down. This technical indicator, at the extremes, indicates market vulnerability.

Consider the example of Tata Steel given in Figure 1. The lower panel shows the price movement of Tata Steel for the period and the upper panel shows the MACD indicator. Observe that there is a bold line and a dotted line. The bold line is the MACD line and the dotted line is the trigger line. The MACD line is the faster line and the trigger line is the slower line. There is also a zero line. When both the curves cross the zero line and rise above it, we say that the market is overbought. The higher the MACD line above zero, greater is the extent to which the market is overheated. When both the curves fall below zero, we say that the market is oversold. It gives clear indication as to when to exit the market and when to enter the market. Over and above, when the bold line crosses the trigger line from below, it is a buy signal. When it crosses it from above, it is a sell signal. When this crossover takes place above or below zero line, the signals are much stronger.

As shown in Figure 2, Metastock gives the buy sell indication also. However, it does not differentiate between whether we are below or above the zero line.

 Figure 1

Figure 2

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