Moving Average Convergence Divergence (MACD)
MACD was developed by Gerald Appel. If you remember our Moving Average chapter, we have discussed double crossovers where one average crosses the other to give a buy/sell signal. MACD exactly deals with the same but in a different overlay using a histogram.
MACD is developed using a simple calculation. The difference of lower EMA and higher EMA is plotted as MACD.
Three strategies can be followed while using MACD.
MACD oscillator consists of a center line with a value 0, positive values (0.5, 1) above and negative values (-0.5,-1) below. When MACD is above zero/centre line, bullish trend is said to be arrived and when the MACD is below the zero line, it is treated as a downward trend.
Signal Line crossover
In addition to MACD, a signal line is introduced in to the oscillator to predict the bull/bear phases. In general, this signal line will be of 9 periods EMA. Leaving histogram and center line, when MACD cuts and moves below the signal line, it’s a bearish crossover. When the signal line cuts and moves below MACD, we call it a bullish crossover.
Divergence is another effective strategy used in MACD method. Divergence is further divided into bullish divergence and bearish divergence. As shown in the figure, if the stock price makes lower low and MACD makes higher low, we call that as Bullish Divergence which indicates that markets may take reverse turn and start to move upside. Keep in mind, while taking stock prices, closing prices should be taken into consideration.
As well, if stock price makes higher high and MACD indicator makes lower high, it is known as Bearish Divergence indicating markets may move down. A sell signal can be taken at this point of time when breakout or signal crossover occurs.