Investment Lessons - Lesson 5 - Technical Analysis

Moving Average Convergence-Divergence

One of the most useful indicators in technical analysis is the Moving Average Convergence-Divergence, or MACD. The system was developed by Gerald Appel, a well-known and very respected technical analyst.

Essentially, the system is a hybrid between an oscillator and a moving average trend following indicator.

The MACD is constructed using three different moving averages, and plotted as two lines.

The first line is the difference between a 12 and 26 period exponential moving average. An exponential moving average is an average which weights the prices of the most recent days more heavily than the early days in the moving average.

The second line, or signal line, is a nine-period exponential moving average of the MACD as calculated above.

Using MACD is one of several confirming signals you should use in your work. A buy or entry signal is issued when the MACD crosses above its own signal line. A sell or exit signal is issued when the MACD crosses below its own signal line.

MACD is accurate in showing market strength since it accomplishes several tasks. First we are measuring whether there is a divergence or convergence between 12 and 26 day prices. A shorter time period (12 day) difference from a longer period. In later lessons we will talk more about how this index is constructed, and why it works.

MACD offers the best of moving averages and oscillators. An oscillator generally has two price zones that represent an overbought or oversold condition. MACD moves with prices and measures momentum and trend and is not restricted to moving in a narrow range.

Look at the chart of the Dow Jones Industrial Average from July to November of 2001. The top window is the MACD, and the bottom window is the DJ 30.

During the period, there were several opportunities for market exit and entry.

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Note that MACD crossed into sell territory the third week in May, and stayed in negative territory (below the signal line) until the second week in July.

The market moved lower from May until July, when it began to move in a trading range, with a slight down-slope, until the end of August. The 50 day moved over the 200 day average during the second week in June, but this signal was not confirmed by MACD.

Then, the 50 day crossed back down below the 200 day moving average the first week in August. This was confirmed by MACD in the last week in August. These two confirming signals would have meant that the participant who moved on the confirming signals would have been out of the market when the Dow went from 10,400 to 8,200 or about 20% of the value of the index.

We have talked about the significance of the 50 day and 200 day moving averages. By having one or more confirming signals to such a move, we can hope to avoid getting “whipsawed” with market moves against us.

MACD is one of the most effective signals for showing breaks in trends, as well as price momentum.

Lesson 6 - Momentum