The rate of change (ROC) is calculated as the difference between two price points, and, hence, is slightly volatile. To make the indicator line smoother, technical analysts use two moving averages, wherein the lines are already smooth. The best example of this is the moving average convergence divergence (MACD). As the name suggests, the MACD tracks the convergence and divergence between two moving averages. Convergence takes place when these moving averages come close to each other, and divergence, when they move away from each other.
Since it is an oscillator constructed using trend-following indicators (moving averages), MACD offers the latter’s benefits as well as that of a momentum indicator. Though any two moving averages can be used to calculate MACD, the most commonly used are 12-day and 26-day ones. However, the investors and traders who want more sensitivity can use shorter moving averages. As is evident from the zero line crossover chart, MACD will come to zero when these moving average values converge and move away from zero when they diverge.
A positive MACD indicates that the short-term moving average is above the medium-term one and, therefore, shows a bullish trend for the stock. Similarly, a negative MACD indicates a bearish trend. This means that the MACD crossing the zero line, which is also known as the central line, is very important and is commonly used as a buy/sell signal. As is clear from the zero line crossover chart, if the MACD cuts the central line from the bottom, it is a buy signal, and when it cuts from the top, it is a sell signal. Since the MACD acts as a trend-following indicator, the zero line crossover will take place with a lag.
As explained earlier, MACD also acts as a momentum indicator. A rising, positive MACD signals that the upside momentum is increasing. Similarly, a falling, negative MACD points at an increasing downside momentum. This means a change in MACD’s direction signals a change in momentum. Plotting a moving average of the MACD line, popularly known as the signal line, is the best way to indentify this turnaround in momentum.
Though any short-term moving average can be used for a signal line, the 9-day moving average is the most commonly used one. The investors and traders who want more sensitivity can use a shorter moving average. How can one interpret this crossover? As is clear from the signal line crossover chart, a bullish crossover occurs when the MACD (blue line) goes above the signal line (red line), and a bearish crossover takes place when the MACD goes below the signal line. However, this is only a turnaround in momentum, not in trend. So, the trading opportunity based on this rule will be of a very small duration.
The third buy/sell rule is based on the theory of divergence. Just like other momentum indicators, divergence occurs when the MACD moves in a different direction compared to the price action of the underlying security. A bearish divergence occurs when the MACD starts making lower tops even though the price continues to create higher tops.
This is clearly marked in the divergence chart, which shows how the upside momentum is slowing down while the uptrend is still on. Since this fall in momentum can foreshadow a possible trend reversal, investors and traders need to be careful. As the MACD loses momentum, it is also possible to generate several false signals based on the signal line.
However, the historical analysis of divergence situations tells us that the third top is the best time to act. In the chart, Cipla has made a significant correction after the third lower top in the MACD. A bullish divergence, on the other hand, occurs when the MACD starts making higher bottoms despite the price making lower bottoms. Here, again, ignore the first two signal line crossovers and buy at the third. To be on the safe side, sell the stock only after the MACD turns negative.
Though MACD is a powerful and commonly used technical indicator, it has drawbacks and, hence, investors/ traders need to take additional precautions while trading on the basis of the above-mentioned rules. This is because these signals may be valid few days, weeks or months and it all depends on the strength of the move. So make sure there is a price/volume confirmation before taking any trading action. To get better results, investors should also use the charts with the right time frame.
Though MACD can be used with the chart of any time frame (daily, weekly, monthly, etc), weekly charts are better for long-term investors who want to use it for timing their entry and exit.
Source : http://articles.economictimes.indiatimes.com/