The Trader’s U E-Letter: Issue # 156
Thursday, October 13, 2005
Technical Indicator: Here’s One That Just Plain Works: MACD Divergence
by D.R. Barton, Jr., Chairman, Trader’s U
“Two indicators diverged on a chart, and I – I shorted a boatload of the stuff, and that has made all the difference.” - with sincere apologies to Robert Frost
Some tools in technical analysis are widely used because they are popular. Others gain a following because they truly work.
The Moving Average Convergence-Divergence (MACD) tool is one such technical indicator that works.
Back in August, when crude oil was hitting another all-time high, I predicted “a near-term top for crude prices.” Since then, prices have dropped as much as 13.7% off of the highs. The tool I used for this forecast: MACD.
Three weeks ago, gold was pushing new multiyear highs. At that point, I stated, “gold seems to have more technical support for a continued move.” Since then, gold is up more than $12 per ounce. Once again, MACD played a large role in my technical analysis.
Today, let’s take a look at the most useful way to use MACD as a technical indicator, and specifically, how I used it in the crude oil and gold forecasts mentioned above.
MACD – Using Divergence as an Ally
In last week’s Trader’s U, we talked about using MACD crossovers… and the fact that they don’t work well.
But here’s a way to use MACD that works. Alexander Elder calls price divergence with the MACD, “the strongest signal in technical analysis.” I can’t argue. (For more on Elder’s book, see “Tips and Tricks” below.)
A MACD divergence is simply a place on a chart where prices make a new high or low, and the MACD fails to make a new high or low at the same time. To see this visually, let’s look at the crude oil chart I used back in the end of August:
Notice that oil was making new highs and the MACD signal line (red) was dropping, as was the MACD histogram (pink bars).
Which part of the MACD should you use to measure divergences? The signal line or the histogram? Either can be used as an indicator. Elder uses the MACD-histogram in his book, claiming it gives stronger, though less frequent, signals than the signal line. I haven’t tested the difference, but anecdotally, I would agree with his assessment.
Now, let’s look at a case where the MACD confirms or shows convergence with the price movement. Look at the gold chart from three weeks ago in the chart below…
Here we see indication of the price powering up to a new multiyear high of $470 (shown by #1 on the chart). But in this case, the MACD confirms the price movement by heading higher (#2).
Avoid Costly Mistakes with Technical Indicators: Don’t Use MACD in a Vacuum
There is one significant note of caution when using MACD divergences. Since we are dealing with price extremes, I always like to look for one more piece of significant analysis to align with the MACD’s interpretation. Note that in the article on investing in oil, I liked the fact that market sentiment (and emotion) were extremely high on oil (sentiment analysis is used as a contrary indicator at the extremes).
Additionally, we had a major news story (Hurricane Katrina) that should have pushed prices much higher, but didn’t. Combining these pieces of information gave a high probability that oil prices had reached a near-term top.
The same integrative analysis applied to gold. I was not content to look at the fact that MACD confirmed the price direction. I also looked at gold’s valuation versus other asset classes and concluded that gold remained fairly valued, or even undervalued, despite the run-up in price.
MACD is very useful as a technical indicator when used in its convergence-divergence role. Combining it with other forms of analysis can enhance its reliability and lead to trading signals that you can use confidently.
Today’s TU Tips & Tricks
- The best discussion that I know of on the practical application of MACD as a divergent indicator is given by Alexender Elder in his excellent book, Trading for a Living.
- To review MACD basics, see the Investment U issues under “Related Articles” below.
Advanced TU: Calculating the MACD (repeated from last week):
1. The MACD fast line is calculated by taking the difference between two Exponential Moving Averages (EMAs) – traditionally the 12 and 26 period EMAs.
2. The MACD signal line is a EMA of the MACD fast line (which traditionally uses 9 period EMA of the MACD fast line).
3. THE MACD histogram is a bar chart that shows the difference between the two lines above. Mathematically, it is the MACD signal line subtracted from the MACD fast line.
4. You can experiment with the periods used for the MACD. In addition to the traditional (12,26,9) that was originally proposed by Appel, you may try shorter periods for shorter time frame trading.
The Chart of the Week – Pat on The Back Edition
This is a chart of the Nasdaq 100 Index (Nasdaq: ^NDX), and it shows that we are approaching a 50% retracement of the move from the March lows to the August highs. Watch the 1,511 price level closely. A significant break of that level could signal much more bearishness for the market. If that level holds, then we could see a rebound. It is also important to note that Microsoft (Nasdaq: MSFT), Intel (Nasdaq: INTC) and Cicso (Nasdaq: CSCO) are all nearing a complete 100% retracement of their moves over the same time period.
Great trading,
D.R.
Related Articles:
Return to Archives
The White Cap Report exclusively identifies companies, White Caps, which - by being among the earliest to gain traction - have secured dominant positions within untapped, billion-dollar markets.
Investment U RSS Feed