Most indicators that are intended to provide some degree of support in a trending market will be derived from moving averages of one type or another.

The best known for most traders is the MACD. This acronym stands for Moving Average Convergence Divergence so called because of the ability to show divergence and convergence of price from the MACD.

Developed by Gerald Appel, the Moving Average Convergence Divergence indicator is one of the simplest and more reliable of the many indicators available. The MACD uses a dual moving average combination that produces a lagging indicator. A lagging indicator tends to follow the trend and will make the trend more visible and measurable. The dual moving average becomes a momentum indicator when the longer moving average is subtracted from the shorter moving average. The line that forms will oscillates around a “zero” line indicating the direction of the market (thetrend) and the slope (the strength of the trend).

The MACD in its simplest form plots the value of the difference between the 12 period exponential moving average (EMA) and the 26 period EMA. The chart above shows this indicator line oscillating about a zero line. The zero line may be thought of as the 26 EMA stretched into a straight line causing the 12 EMA oscillations to exaggerate substantially. This occurs because the crossover points of the 26 EMA and the 12 EMA must still occur at the same point which has now become the zero plane. Think of the two lines pinned together where they cross and now mentally stretch the 26 EMA into a straight line.

The next stage in the development is to change the oscillator line to a histogram presentation. This is achieved by drawing a series of vertical lines from the zero line to the indicator line and erasing the indicator line.

The indicator now presents the appearance of “bulk” inside the oscillations. As these oscillations contain the majority of the sentiment moving the market, this can be appropriate.

An elementary assessment of the market is that the greater the amount of “bulk above or below the zero line, the lower becomes the probability of the market continuing in the same direction. The next development is to add a 5 SMA of the indicator line (26 EMA - 12 EMA).

This produces a “trigger line” or a line that may be used as a further condition line.

The adjacent chart shows the entry and exit positions if signals were acted on at the signal lines crossover. It should be obvious that such a system is quite inefficient and can require some large draw downs in the process.

An important message from the MACD is that of divergence. In the example above we see the upward slope of the price action increase in comparison to the upward slope of the tops of the MACD. This condition is described as class 3 divergence and is often the precursor to more extreme divergence. The second line shows class 1 divergence with the tops of the MACD moving in the opposite direction to that of the price action.

As both the signal lines and the histogram convey a message it is no surprise to find the MACD combo in the tool box. This presentation of the MACD plots both the histogram and the signal lines together. The histogram tends to be diminished in scale and consequently appears less important. This is not the case and care should be taken to assess the histogram message. Note that the signal line crossovers occur where the histogram crosses the zero line. The distance the histogram extends above or below the zero line is proportional to the distance between the signal lines.

The buy and sell signals generated by crossovers are not very efficient and for use as a trading tool, supplementary filters are required. Like all moving average derived instruments, the MACD works satisfactorily in well trending markets but poorly in soft trends or ranging markets.

Observation will show that the histogram leads the averages however; signals taken from the histogram will induce many false entries. Signals taken from the signal lines, regardless of how far above or below the zero line they may be, will result in many late entries and exits.

Having said that, it is worth noting that if the fast line crosses over the slow line above the centreline it is often the case that a bullish trend will continue. The steepness of the signal lines following a crossover also provides an indication as to the potential strength of the trend.

The dominant use of the MACD is to provide an assessment of the market in terms of;

• Is the current price move in an early or late stage of development?
• How far above or below the zero line are the signal lines?
• How much “bulk” is in the histogram bumps?
• Is the market supportive of a signal given by price? Is the MACD in a buy or sell condition?
• Is supporting divergence present?
• Is the signal with the trend or countertrend?
• Is the long term condition of the market likely to continue?
• Are the signal lines and the histogram higher or lower that ever before?
• What changes are occurring in the signal lines between time frames?

The next few pages contain charts that will allow the identification and verification of the statements above.

The primary buy signal on Telstra confirmed by divergence and signal line crossovers at the time the signal lines are crossing the zero line.

The All Ordinaries Index monthly is showing a large stretch above the 1987 event. This is accompanied by bearish divergence on the histogram.

The probability of a decline is high. The MACD on a weekly chart of the All Ordinaries Index also suggests a large decline lies somewhere ahead.