MACD: Part 2

In last issue’s Technically Speaking column, we introduced the moving average convergence-divergence (MACD) indicator. This indicator combines the trend-following characteristics of moving averages with oscillator traits that help identify overbought or oversold conditions in a security and pinpoint possible divergences between the indicator and the security’s price. To learn about the basics behind the MACD, refer to the Second Quarter 2012 issue of CI, which is available here. In the second part of this series, we discuss how traders can make use of the MACD.

Crossovers

There are two types of crossovers to look for when using the MACD—signal line crossovers and centerline crossovers. Signal line crossovers are the most commonplace. Remember that the signal line is the nine-day exponential moving average (EMA) of the MACD line, which means it lags the MACD line while also smoothing it. A bullish crossover takes place when the MACD line crosses above the signal line. In contrast, a bearish crossover occurs when the MACD line crosses below the signal line.

Since they occur so frequently, it is important to consider these crossovers carefully before acting upon them. Figure 1 shows the signal line crossovers—indicated by the red and green arrows between the upper and lower panes—for Illinois Tool Works, Inc. (ITW) between late August 2011 and February 2012. During this period there were five signal line crossovers—three down and two up.

The bearish crossover in late September 2011 lasted less than a week. However, it was followed by a bullish crossover that preceded a stock price increase of roughly 9% in a little over a month. The second bullish crossover in early December 2011 was followed by a price increase of over 20% before a bearish crossover on February 15, 2012. Note that this crossover took place when the MACD was at an extremely positive level. Crossovers at such extremes—positive or negative—should be viewed with caution. It takes a lot of positive or negative momentum to push the MACD to extreme levels. Even though in this example the signal line generated a bearish signal, this could simply be pointing to a slowing in upward momentum and not an actual reversal in the uptrend.

Another common MACD signal is a centerline crossover. Bullish centerline crossovers take place when the MACD line moves above the zero line, or centerline, and into positive territory. This marks the point where the 12-day EMA moves above the 26-day EMA. A bearish centerline crossover occurs when the MACD line moves into negative territory—when the 12-day EMA moves below the 26-day EMA.

Figure 2 shows four centerline crossovers for Mastercard (MA) between August 2011 and February 2012. As you can see from this chart, centerline crossovers can last a few days or several months. The stronger the trend, the longer the MACD line will remain in either positive or negative territory.

The two yellow zones on the chart show when the MACD line is below the centerline. The first time, MA shares actually rose, while the second time shares moved mainly sideways.

The first positive crossover took place after MA shares had already risen over 10% from their early-October low. The second came after the price had risen over 12% from their January 2012 lows.

These examples illustrate the varying levels of success you can achieve using the MACD by itself.

Divergences

Divergences take place when an indicator diverges from the price action of the underlying security. In the case of the MACD, a bullish divergence occurs when the security is forming lower lows while the MACD line is forming higher lows. The lower prices affirm the current downtrend, but a lack of corresponding lower lows in the MACD line indicates a slowing in the downward momentum. This, in turn, may foreshadow a trend reversal.

Figure 3 illustrates bullish divergence in MACD for Kimball International, Inc. (KBALB) in August and September 2011. Throughout August and September, KBALB shares hit a series of reaction lows. However, as Kimball shares were hitting new lows in late September, the MACD line was forming a higher low. This was followed shortly thereafter by a signal line crossover, which was confirmed with a resistance breakout in mid-October.

A bearish divergence occurs when prices are forming higher highs, yet the MACD is forming lower highs. While higher highs are normal during an uptrend, lower highs on the part of MACD may indicate slowing upside momentum which, eventually, may result in a price reversal to the downside.

Figure 4 is an example of bearish divergence between the shares of V.F. Corp. (VFC) and its MACD. Between February and May of this year, VFC shares hit several intermediate highs while the MACD line was in steady decline. In early May, the share price reversed course, breaking through support while the MACD signal line crossed over to the downside.

Conclusion

The MACD takes a simple trend-following indicator—the moving average—and turns it into a momentum oscillator. With it we can measure the price momentum of an underlying security and identify where waning momentum may be signaling an upcoming price reversal.