MACD: averages in a single oscillator

When you drive a car uphill, the speedometer shows how fast you are going, but it is acceleration that tells you whether you are pressing the pedal or easing off. MACD is a sort of acceleration of price: it shows not so much where the market is as whether its pace is rising or falling. Before price changes direction, the pace usually slows, and that is exactly what MACD tries to catch.

What you will learn

• what MACD is made of: the line, the signal line and the histogram,
• how to read crossovers and the zero line,
• when MACD lies and why its values cannot be compared between stocks.

How MACD is built

The indicator was developed in the late 1970s by Gerald Appel. The name stands for Moving Average Convergence Divergence. It has three elements, all of which follow from the lesson on averages:

• The MACD line = EMA(12) − EMA(26). The difference between a fast and a slow exponential average.
• The signal line = EMA(9) of the MACD line. A smoothed version of the indicator itself.
• The histogram = MACD line − signal line. It shows how far apart the two lines are.

When price rises fast, the short average runs away from the long one and MACD rises. When price stands still or falls, the two averages come closer together and MACD falls. The MACD line therefore measures how far the fast average is ahead of the slow one: the bigger the difference, the stronger the pace.

How to read MACD

• Zero-line cross. When the MACD line moves from below zero to above, EMA(12) has moved ahead of EMA(26): that is the same as a crossover of two averages, only in a different form. Above zero the upward pace prevails, below it the downward one.
• Signal-line cross. When MACD crosses the signal line from below, the pace starts accelerating upward. From above, the pace is fading. This is a more frequent signal, but also more prone to false alarms.
• The histogram. It is the first derivative of the pace: when the bars grow, acceleration rises; when they start to shrink, the pace is slowing, often before price changes direction. It is good to watch, but react only when the chart confirms it.

An interesting way to use it: MACD on the weekly chart as a direction filter. If weekly MACD is above zero and the daily one gives an upward signal, the agreement of the windows (lesson 8) strengthens the picture.

What MACD does not do

MACD is not limited to a range like RSI. Its value is expressed in price units, so you cannot compare the MACD of two stocks with different prices. A MACD of 5 on a 500 stock is something completely different from 5 on a 50 stock. For comparisons you need to normalise, for example by dividing by the price.

Chart example: Amazon (AMZN), daily chart

Amazon is a huge, liquid stock whose daily chart over the last two years contains both clear trends and longer periods of sideways movement. It is a good comparison: MACD behaves quite differently in a trend and in a consolidation.

Open the daily chart of AMZN and add MACD (12, 26, 9). Find one stretch of a clear trend and one stretch of sideways movement. In each, count how many times the MACD line crossed the signal line and how many of those crossovers were actually followed by a price move in that direction over the next 10 sessions. The difference between the two stretches will be clear.

MACD in practice: three questions

Instead of looking for a "signal" in every crossover, ask three questions, always in the same order:

1. Where is the MACD line relative to zero? Above zero the upward pace prevails, below it the downward one. That is the context.
2. What is the histogram doing? Is it growing, so the pace is accelerating, or shrinking, so it is slowing?
3. Does the chart confirm it? Structure (lesson 1) and levels (lesson 2) count: MACD without confirmation from price is only a description of pace.

It is also worth setting MACD beside the RSI from the previous lesson. When RSI stays in the band typical of an uptrend and MACD is above zero, both indicators say the same thing in different languages: the pace is on the buyers' side. When they diverge, note it as a warning. We will come back to this topic in the lesson on divergences.

How it fails

• Lag. MACD relies on three smoothings, so signals come after the fact. The histogram is faster but nervous.
• A flat market. In a consolidation both averages tangle around each other and MACD crosses the signal line every few sessions. Every crossover is false.
• No comparability. Do not compare MACD values between stocks, or even for the same stock after a multiple change in price.
• Parameter fitting. The 12, 26, 9 parameters are a convention. By tuning them to history you will always find a setup that "worked". That is not proof for the future.

Check yourself

1. What are the MACD line and the signal line made of?
2. What does the histogram show?
3. What does the MACD line crossing zero mean?
4. Why is the MACD value not compared between stocks of different price?

Next lesson

Lesson 11. Volatility: ATR and Bollinger Bands: the market breathes: sometimes shallowly, sometimes deeply. When the bands tighten, something is brewing, but what? You will learn to measure the market's breathing with a single number and see why it decides where your stop goes.

Educational material, not investment advice.