MACD Histogram

The MACD Histogram (MACD-H) consists of vertical bars showing the difference between the MACD line and its signal line . The MACD Histogram is useful for anticipating changes in trend. A change in the MACD-H will usually precede any changes in MACD. Signals are generated by direction, zero line crossovers and divergence from MACD. As an indicator of an indicator, MACD-H should be compared with MACD rather than with the price action of the underlying market. MACD-H is used with MACD as a complementary indicator.

Thomas Aspray found that MACD signals often lagged important market moves, especially when applied to weekly charts. He first experimented with changing the moving averages and found that shorter moving averages did indeed speed up the signals. However, he was looking for a means to anticipate MACD crossovers and came up with the MACD Histogram.

Interpretation

The MACD Histogram represents the difference between MACD and it's signal line (usually the 9-day Exponential Moving Average (EMA) of the MACD). Whenever MACD crosses the signal line, MACD-H crosses the zero line.

• If the MACD line is above the signal line, the histogram is positive, and the bars are drawn above the zero line.
• If the MACD line is below the signal line, histogram is negative, and the bars are drawn below the zero line.

Sharp increases in the MACD-H indicate that MACD is rising faster than its 9-day EMA and upward momentum is strengthening. Sharp declines in the MACD-H indicate that MACD is falling faster than its moving average and downward momentum is increasing. Divergences between MACD and MACD-H are the main tool used to anticipate crossovers. A positive divergence in the MACD-H indicates that MACD is strengthening and could be on the verge of a bullish moving average crossover. A negative divergence in the MACD-H indicates that MACD is weakening and can act to foreshadow a bearish moving average crossover in MACD.

Signals

The main signal generated by the MACD-Histogram is a divergence from MACD followed by a zero-line crossover.

• A bullish signal is generated when a positive divergence forms and there is an upward zero line crossover.
• A bearish signal is generated when there is a negative divergence and a downward zero line crossover.

In Technical Analysis of the Financial Markets, John Murphy states that the real value of the MACD-H is spotting when the spread between the two lines is widening or narrowing. When the histogram is above its zero line (positive) but starts to fall, the uptrend is weakening. Conversely, when the histogram is below its zero line (negative) and starts to rise, the downtrend is losing momentum. These turns of the histogram provide early warnings that the current trend is losing momentum, and the buy or sell signal is given when the histogram crosses the zero line.

Murphy also advocates a two-tiered approach in order to avoid making trades against the major trend. The weekly MACD-H can be used to generate long-term signals. Then only short-term signals that agree with the major trend are used.
• If the long-term trend is up, only positive divergences with upward zero line crossovers are considered valid for the MACD-H.
• If the long-term trend is down, only negative divergences with downward zero line crossovers are considered valid.

Used this way, the weekly signals become trend filters for daily signals. This prevents using daily signals to trade against the overall trend.

How to Trade Using MACD

The MACD indicator is primarily used to trade trends and should not be used in a ranging market. Signals are taken when MACD crosses its signal line, calculated as a 9 day exponential moving average of MACD. The basic MACD trading rule is to sell when the MACD falls below its 9 day signal line and to buy when the MACD rises above the 9 day signal line. Apart from signal line crossovers, traders can look for centerline crossovers and divergences to generate signals.

Signal Line Crossovers

Signal line crossovers are the most common MACD signals. The signal line is a 9-day EMA of MACD. As a moving average of the indicator, it trails MACD and makes it easier to spot turns in MACD. A bullish crossover occurs when MACD turns up and crosses above the signal line. A bearish crossover occurs when MACDturns down and crosses below the signal line. Crossovers can last a few days or a few weeks, it all depends on the strength of the move.

Signal crossovers are quite common. As such, due diligence is required before relying on these signals.Signal line crossovers at positive or negative extremes should be viewed with caution.It takes a strong move in the underlying security to push momentum to an extreme. Even though the move may continue, momentum is likely to slow and this will usually produce a signal line crossover at the extremities. Volatility in the underlying security can also increase the number of crossovers.

Below Chart shows IBM with its 12-day EMA (green), 26-day EMA (red) and MACD (12,26,9) in the indicator window. There were eight signal line crossovers in six months: four up and four down. There were some good signals and some bad signals. The yellow area highlights a period when MACD surged above 2 to reach a positive extreme. There were two bearish signal line crossovers in April and May, but IBM continued trending higher. Even though upward momentum slowed after the surge, upward momentum was still stronger than downside momentum in April and May. The third bearish signal line crossover in May resulted in a good signal.

Centerline Crossovers

MACD oscillates above and below the zero line, which is also known as the centerline. Centerline crossovers are the next most common MACD signals. These crossovers signal that the 12-day EMA has crossed the 26-day EMA. The direction, of course, depends on direction of the moving average cross. A bullish centerline crossover occurs when MACD moves above the zero line to turn positive.This happens when the 12-day EMA of the underlying security moves above the 26-day EMA. A bearish centerline crossover occurs when MACD moves below the zero line to turn negative.This happens when the 12-day EMA moves below the 26-day EMA.

Centerline crossovers can last a few days or a few months. It all depends on the strength of the trend.MACD will remain positive as long as there is a sustained uptrend. MACD will remain negative when there is a sustained downtrend.Above Chart shows Pulte Homes (PHM) with at least four centerline crosses in nine months. The resulting signals worked well because strong trend emerged soon thereafter.

Below Chart shows 3M (MMM) with a bullish centerline crossover in late March 2009 and a bearish centerline crossover in early February 2010. This signal lasted 10 months. In other words, the 12-day EMA was above the 26-day EMA for 10 months. This was one strong trend.

DIVERGENCES

DIVERGENCES FORM WHEN MACD DIVERGES FROM THE PRICE ACTION OF THE UNDERLYING SECURITY. A BULLISH DIVERGENCE FORMS WHEN A SECURITY RECORDS A LOWER LOW AND MACD FORMS A HIGHER LOW. THE LOW LOWER IN THE SECURITY AFFIRMS THE CURRENT DOWNTREND, BUT THE HIGHER LOW IN MACD SHOWS LESS DOWNSIDE MOMENTUM. THE SLOWING OF THE DOWNTREND SOMETIMES FORESHADOWS A TREND REVERSAL OR A SIZABLE RALLY.

BELOW CHART SHOWS GOOGLE (GOOG) WITH A BULLISH DIVERGENCE IN OCTOBER-NOVEMBER 2008. THE MACD MOVING AVERAGES ARE BASED ON CLOSING PRICES AND WE SHOULD CONSIDER CLOSING PRICES IN THE SECURITY AS WELL. NOTICE THAT THERE WERE CLEAR REACTION LOWS IN OCTOBER AS GOOGLE BOUNCED FOR A FEW WEEKS AND MACD MOVED ABOVE ITS SIGNAL LINE.MOREOVER,MACDFORMED A HIGHER HIGH AS GOOGLE FORMED A LOWER LOW IN NOVEMBER. THIS BULLISH DIVERGENCE WAS CONFIRMED WITH A SIGNAL LINE CROSSOVER IN EARLY DECEMBER.

A BEARISH DIVERGENCE FORMS WHEN A SECURITY RECORDS A HIGHER HIGH AND MACD FORMS A LOWER HIGH. THE HIGHER HIGH IN THE SECURITY IS NORMAL FOR AN UPTREND, BUT THE LOWER HIGH IN MACD SHOWS LESS UPSIDE MOMENTUM. WANING UPWARD MOMENTUM CAN SOMETIMES FORESHADOW A TREND REVERSAL OR SIZABLE DECLINE.

BELOW CHART SHOWS GAMESTOP (GME) WITH A LARGE BEARISH DIVERGENCE FROM AUGUST TO OCTOBER. THE STOCK FORGED A HIGHER HIGH ABOVE 28, BUT MACD FELL SHORT OF ITS PRIOR HIGH AND FORMED A LOWER HIGH. THE SUBSEQUENT SIGNAL LINE CROSSOVER AND SUPPORT BREAK IN MACD WERE BEARISH. TURNING BACK TO THE GME PRICE CHART, NOTICE HOW BROKEN SUPPORT TURNED INTO RESISTANCE ON THE THROWBACK BOUNCE IN NOVEMBER (RED DOTTED LINE). THIS THROWBACK PROVIDED A SECOND CHANCE TO SELL OR SELL SHORT.

DIVERGENCES SHOULD BE TAKEN WITH CAUTION. BEARISH DIVERGENCES ARE COMMONPLACE IN A STRONG UPTREND, WHILE BULLISH DIVERGENCES OCCUR OFTEN IN A STRONG DOWNTREND. UPTRENDS OFTEN START WITH A STRONG ADVANCE THAT PRODUCES A SURGE IN UPSIDE MOMENTUM (MACD). EVEN THOUGH THE UPTREND CONTINUES, IT CONTINUES AT A SLOWER PACE THAT CAUSESMACD TO DECLINE FROM ITS HIGHS. THE OPPOSITE OCCURS AT THE BEGINNING OF A STRONG DOWNTREND.

CONCLUSIONS

MACD IS SPECIAL BECAUSE IT BRINGS TOGETHER MOMENTUM AND TREND IN ONE INDICATOR. THIS MEANSMACD WILL NEVER BE FAR REMOVED FROM THE ACTUAL PRICE MOVEMENTS OF THE UNDERLYING SECURITY. THIS UNIQUE BLEND OF TREND AND MOMENTUM CAN BE APPLIED TO DAILY, WEEKLY OR MONTHLY CHARTS. MACD IS NOT PARTICULARLY GOOD FOR IDENTIFYING OVERBOUGHT AND OVERSOLD LEVELS. EVEN THOUGH IT IS POSSIBLE TO IDENTIFY LEVELS THAT ARE HISTORICALLY OVERBOUGHT OR OVERSOLD, MACD DOES NOT HAVE ANY UPPER OR LOWER LIMITS TO BIND ITS MOVEMENT. MACD CAN CONTINUE TO OVEREXTEND BEYOND HISTORICAL EXTREMES DURING SHARP MOVES.

Moving Average Convergence-Divergence (MACD)

Introduction

Developed by Gerald Appel in the late seventies, Moving Average Convergence-Divergence (MACD) is one of the simplest and most effective momentum indicators available. The MACD indicator is basically a refinement of the two moving averages system and measures the distance between the two moving average lines. It turns two trend-following indicators (moving averages), into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, MACD offers the best of both worlds: trend following and momentum. MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals. Because MACD is unbounded, it is not particularly useful for identifying overbought and oversold levels.

Calculation

MACD: (12-day EMA - 26-day EMA)

Signal Line: 9-day EMA of MACD

MACD Histogram: MACD - Signal Line

Standard MACD is the 12-day Exponential Moving Average (EMA) less the 26-day EMA. Closing prices are used for these moving averages. A 9-day EMA of MACD is plotted along side to act as a signal line to identify turns in the indicator. The MACD -Histogram represents the difference between MACD and its 9-day EMA, the signal line. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.

In the chart above, the black line (MACD) is the moving average of the difference between the 12 and 26-period moving averages. The red line (Signal Line) plots the average of the last 9 periods of the black line (MACD). This smoothens out the MACD even more, which gives us a more accurate line. The histogram simply plots the difference between the MACD and the Signal Line.

If you look at above chart, you can see that, as the MACD and the Signal Line separate, the histogram gets bigger. This is called divergence because the faster moving average is "diverging" or moving away from the slower moving average. As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is "converging" or getting closer to the slower moving average. Hence it got the name, Moving Average Convergence Divergence.

COMMONLY USED MOVING AVERAGES

Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and resistance points and are very easy to use. The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of two weeks.

Shorter moving averages will be more sensitive and generate more signals. However, there will also be an increase in the number of false signals and whipsaws. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability. Once you have found a combination that works for you, then stick by it so you get a feel for the signals that those particular averages generate. There is no one moving average or combination with a special power; the key point is to represent the moving averages in various, multiple time frames.

THREE MOVING AVERAGES COMBINATION

Most traders use the combination of three averages. By combining multiple moving averages, you'll be able to come up with a clear answer to what the trend is in different time frames and whether the trends in the different time frames are aligned with one another. Futures traders use the combination like 5, 10 and 20 period averages. Stock traders use longer periods like the 50 day, 100 day and 200 day to generate trading signals. When the short period average crosses the medium one, this gives a trading signal but this need to be confirmed. Confirmation is obtained when the short and the medium move above the longer period average.

For short, medium or long term trades, one can use the combination of 20 and 50 period Exponential Moving Average (EMA) and the 200 period Simple Moving Average (SMA). Combining moving averages from multiple time frames will allow you to determine when the trends from all three periods are in your favor. By synthesizing all of these various moving averages, you will greatly increase your chances of profitable trading.

THE 20 & 50 PERIOD MOVING AVERAGES

The 20 and 50 EMAs track the prices closer and help in determining structure (uptrend/downtrend) .They also aid in developing low-risk, high probability trade set-ups (entries) in a trending environment (for example, buying pullbacks to the 20 or 50 EMA in a rising trend.). You can see in the chart below how these lines can help you define trends. On the left side of the chart the 20 EMA is above the 50 EMA and the trend is up. The 20 EMA crosses down below the 50 EMA (after May 10) and the trend is down. Then, the 20 EMA crosses back up through the 50 EMA (in September 10) and the trend is up again - and it stays up thereafter. Focus on long positions only when the 20 EMA is above the 50 EMA. Focus on short positions only when the 20 SMA is below the 50 EMA. It doesn't get any simpler than that and it will keep you on the right side of the trend.

Here are the important things to remember (for long positions - reverse for short positions.):

Ø The 20 SMA must be above the 50 EMA.

Ø Their must be plenty of space in between the moving averages.

Ø Both moving averages must be sloping upward.

THE 200 PERIOD MOVING AVERAGE

The 200 SMA is the most important moving average to have on a stock chart. The 200 SMA is used to separate bull territory from bear territory. Studies have shown that by focusing on long positions above this line and short positions below this line can give you a slight edge. Also, many funds follow the 200 day or week SMA and that might be all the technical analysis they use, so it tends to cause ‘reactions’ and is an important level to watch. You will be surprised at how many times a stock will reverse in this area (look at the chart above).

Moving averages are one of the most powerful trend-following tools available to the trader. But they only work well when a stock is trending - not when they are in a trading range. When a stock (or the market itself) becomes "sloppy" then you can ignore moving averages - they won't work. Moreover, they should not be used in isolation. Instead, you should use moving averages in conjunction with Chart Pattern Analysis, Candlesticks and indicators such as MACD and Stochastics to create powerful and profitable Technical Analysis.