This is the simplest technical tool used by analyst to predict stock trends. MACD stands for Moving Average Convergence Divergence and was originally developed by Gerald Appel. This technique has gained popularity among traders for its reliability in predicting broad direction or state of market, though it does not provide exact entry or exit points as other indicators but gives the direction of the stock quite consistently.
Construction of MACD
Following are the graphs you will find when you draw MACD of any stock
- MACD itself is constructed by subtracting the Long Term Moving Average of the stock from Short Term moving average. Typically the Long Term is taken as recent 26 days and the Short Term is taken as recent 13 days. The Short Term Moving Average is obviously more responsive than its longer sibling hence the difference is plotted as a line graph. The plot will oscillate above and below zero, with no upper or lower limits. It is usually drawn Blue in color.
- The Signal Line is the Moving Average of the MACD itself and is drawn Red.
- There would a be histogram that is a visual aid of the difference between the Signal line and MACD oscillator
In a Charting Software you would find both Fast MACD and Slow MACD.
Fast MACD is generally constructed by taking moving averages of 10 and 5 days to show recent developments and is more responsive but is prone to give false signals. The Slow MACD is constructed by taking 26 days and 12 days MA, though it is less responsive to recent changes but is more accurate in prediction
Understanding the Signals
Positive & Negative MACD
We use EMA instead of simple MA as EMA gives more importance to recent prices. We are using (26, 12) day EMA in our example to understand the signal. MACD is positive and increasing in value shows that short-term price is rising more than the long-term rate and the stock is attaining momentum. Negative MACD occurs when 12 day EMA is lower than the 26 day EMA and if the trajectory is downward then it depicts a bearish direction.
In our example of Mcleod Russel watch how MACD is giving both bullish and bearish signal two three days before the actual trend start
There are two types of crossovers:
Signal Line Cross: When the MACD crosses the Signal Line (9 day EMA of MACD) from below and moves above, it indicates a bullish signal
Centre Line Crossover: The bullish crossover of centreline is also a common indicator and happens when the MACD crosses the zero line and moves above it. Watch the above chart.
When the MACD starts to move higher or lower and stock prices fail to move it created divergence. It gives a signal that there is impending price action in the direction of MACD. It is not very easy to carve out these patterns but it is very reliable in predicting the direction of the mov
In the below chart of JP associates look how stock prices are moving upwards but MACD is going down, eventually the stock prices just breaks down following the MACD.
Negative divergences are very rare but depict the most reliable prediction. The happen when security remains sideways but the MACD moves downwards and shows peaking off.
This article was written by Prasenjit Gupta, who is an investment banking professional known for his advisory abilities in critical matters.