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The MACD is one of the most commonly used indicators, but what is behind this graceful construct?
A week ago, we took a fundamental look at the subject of indicators at this point. They are a potential tool for every trader to make meaningful decisions. In this way they can certainly contribute to one’s own success, but they should not be overestimated in terms of their forecasting abilities. Of course, indicators can be used to derive possible future scenarios for the underlying asset in question and perhaps even to rank it, but this is of course far from the desire to take a look into the crystal ball. If you take this thought to heart and also keep in mind that standard interpretations should be treated with caution, the wide range of indicators opens up a thoroughly interesting world. Reason enough to take a closer look at some of the classic indicators – today with the MACD.
Typical for indicators is their English and therefore often complicated sounding name. The abbreviation MACD stands for Movering Average Convergence Divergence and was developed by G. Appel in the 70s of the last millennium. In its original form, the MACD is based on two exponentially smoothed averages whose difference is measured. Figure 1 shows the price development of the DAX together with an exponential moving average of 12 and 26 directly in the chart window and below it the MACD line.
In its default setting, the MACD uses the 12 and 26 exp moving averages and is calculated by subtracting the longer average from the shorter one:
MACD = exp.GD(12) – exp.GD(26)
At the current DAX level of 9,610.13 points and the respective averages of 9,438.20 points for the GD(12) and 9,243.95 points for the GD(26), this results in a MACD value of 9,438.20 – 9,243.95 = 194.25 points (see Fig. 1). This can of course still change in the course of today and is only fixed with the closing price of each candle. You should not forget this small banality when it comes to deriving signals from the MACD later on. After all, it can happen to you during the development of a candle that one second a valid buy signal is displayed, which is no longer there a short time later. Only when the candle is “ready”, the indicator can be interpreted with certainty.
1) Interpretation of the MACD
In our introductory article on indicators, we have already seen that we can distinguish indicators into trend followers, oscillators and momentum indicators, but that this division has no sharp boundaries and transitions are fluid. The MACD is a good example of this.
As a trend-following indicator, it can show the trend direction as well as the trend strength. As is often the case, the MACD also allows different interpretations, some of which will be shown here.
Basic position of the MACD to its zero line
In theory, the MACD can take on infinitely large positive and negative values, but in practice the difference between the two moving averages, i.e. the value of the MACD, is limited by the volatility of the underlying market. A MACD in positive territory indicates a bullish market environment, while a MACD remaining in negative territory indicates a bear market. If the MACD rises in positive territory or falls in negative territory, the trend accelerates, while a falling MACD above the zero line suggests a weakening upward trend momentum. Vice Versa, a rising MACD below the zero line suggests that the downward momentum is weakening. Both interpretations – that of the trend direction as well as the trend strength – result directly from the calculation of the MACD. After all, the MACD merely shows the position of two moving averages relative to each other. From this, a first signal for the MACD can also be directly derived, the intersection with the zero line, which is associated with the crossing of the two moving averages. If the indicator comes out of the bearish zone and rises above the zero line, a buy-signal is given (the two moving averages cross each other bullishly), while a breaching of the zero line out of the bullish zone is equivalent to a sell-signal. This is shown in figure 2.
If we apply this simple trading system to the DAX from July 1996 onwards and take into account approx. 2 points cost per trade and always buy/short 1 CFD, a profit of just under 5,940 points results (Fig. 3).
The trader is always in the market and on his own, the performance does not look that bad at first. However, this is noticeably put into perspective, as the DAX was able to gain approx. 7,100 points in the same period with a buy&hold strategy. Moreover, the system produces relatively long dry spells. If the system was launched in 2009, the trader would still be operating in the red today. Furthermore, the performance report in Figure 4 shows the typical characteristics of a trend strategy.
For example, the trader must be able to handle a hit rate of less than 30%. On the short side, the hit rate was only 22.39% and the tactic itself was not profitable (minus 281.99 points). A first filter in practice therefore suggests that, in relation to the DAX, the MACD should only be considered on the long side in its standard setting.
On the other hand, disillusionment creeps in when we apply the MACD to a rather difficult candidate such as Adidas shares. Even without costs, traders have no chance here. The tactic has worked exclusively in negative territory in recent years (see Figure 5). This is due to the strong tendency towards larger and smaller sideways movements, in which the MACD constantly crosses the zero line without a sufficiently large trend being able to establish itself afterwards.
In both cases, the trader can try to improve the result by choosing the period lengths. The larger the period selected, the larger trends are taken into account, whereby the trading frequency should tend to decrease. The smaller the selected period length, the shorter trends are taken into account by the MACD and the trading frequency will tend to increase.
2) MACD and signal line
If you apply the MACD indicator in your charting tool like Guidants, you will not only be confronted with one line (the original MACD line as described above), but you will face mdst. another line, the signal line. This moving signal line is nothing more than a smoothing of the MACD line. A further moving average is placed on the MACD, whereby a period length of 9 is selected in the standard setting (see Fig. 6).
The same entry and exit logic can now be derived from this as in the first case. If the MACD crosses the signal line from bottom to top, a buy signal is present and vice versa. In addition, the position of the signal in relation to the zero line can now also be taken into account. In general, buy signals from MACD and signal line are considered “better” if they occur below the zero line (sell signals vice versa). However, the short section of the DAX shows even without a major test that the signal quality of MACD and signal line leaves much to be desired. Here, the weekly chart of the DAX from the end of 2012 until summer 2013 shows constant crossings of MACD and signal line, while the DAX obviously remained in a nice uptrend during this time.
3) MACD Histogram
If we summarize the first two “trading opportunities”, the joy of seeing the MACD indicator perform is likely to be limited. One could simply sum up the difficulties: there is simply a lot of overlap. This is what resourceful traders thought and tried to further improve the MACD. The result was the MACD histogram. With the original MACD line and the newly added signal line (Fig. 6), we again have a system with two moving averages. Since the basic logic of MACD sounds coherent, the next step was obvious: we turn the MACD to the MACD. Ready is the histogram, which again represents nothing more than the difference between the original MACD and its signal line. Figure 7 now shows the complete MACD indicator in its current form.
Just by looking at clear crossroads, the original MACD with its simplicity and clarity has become a multi-faceted indicator. However, this does not yet reflect the full range of possible applications of the MACD – probably not least because the performance of the generated signals left something to be desired. Often the trader encounters the MACD nowadays mainly with regard to divergences in the original MACD line as well as in the histogram. A bullish divergence is when the price of the underlying asset falls while the MACD or histogram is already rising. This indicates a decreasing dynamic in the downward movement and thus a possible trend reversal. The same applies to bearish divergences, but naturally on the opposite side. While the price continues to rise, the MACD or the histogram already begins to fall. Divergences can be looked for thereby for each of the regarded lines separately as well as in combination among themselves and have thereby rather filtering character. As pure entry or exit signal these are less suitable. Figure 8 shows both a bullish and bearish divergence in the histogram, where the basic principle is clearly shown, but at the same time the necessity of an additional signal is underlined. As can be seen, the bearish divergence drags on for a long time before the first major downward movement in the DAX occurs.
5) who hasn’t had enough yet…
As seen so far, the MACD All is an extremely comprehensive indicator with massive potential. These do not stop with the described aspects, however, yet. Traders can also evaluate the histogram in great detail (bars are viewed individually and the position of the current candlestick is compared with the position of the last candlestick) or they can concentrate on the MACD line and its course (divergences). In addition, there is the possibility to play around with the selected period lengths for an infinite period of time and/or to combine the individual signals of the MACD with each other and with other signals. Of course, you can also in a proprietary development another MACD on the MACD on the MACD. Only your imagination is limited here – after all, the classic MACD and all other indicators are created exactly the same way.
With the MACD, one of the more complex indicators in our series on indicators was presented. The basic construction of the MACD is simple – but also obvious: the difference between two averages can be used to say something about the trend direction and strength. Practical application has shown, however, that this indicator does not provide a glass ball either, so its further developments were not surprising. To what extent these are a curse or a blessing for the trader, you have to decide for yourself, after all, these make the indicator incredibly complex. The first test of the MACD on the DAX made here shows that the indicator has a quite interesting basis, but should not be used blindly (see Performance in Adidas). There are plenty of expansion possibilities, but the trader is confronted with an increasingly complex system that also gains room for interpretation. If the crossing of the MACD line with the zero line was a quickly recognizable pattern even for a child, the complexity and thus the scope for interpretation in divergence analysis increases massively. A blind application of the MACD in its standard interpretation cannot be recommended at this point, however.