Ignoring Signals is the First Step to Taking Signals - How Well do you Know MACD?

 Two Indicators in One

Indicators generate lots of signals and many of these signals are just noise. It is imperative that chartists understand how their indicators work and exactly what these indicators are saying. Understanding the ins and outs of an indicator will help chartists determine which signals to take seriously and which signals to ignore. Today we will look at MACD, one of the most popular momentum indicators. 

MACD, which stands for moving average convergence divergence, measures the convergence and divergence of two exponential moving averages by subtracting the longer EMA from the shorter EMA. The moving average crossovers make MACD a trend indicator, while the moving average differential adds a momentum aspect. In fact, MACD is really two indicators in one. 

MACD as a Trend Indicator

Moving averages are classic trend indicators and MACD can be used to identify moving average crossovers. The trend turns up when a shorter moving average moves above a longer moving average and down when a shorter moving average moves below a longer moving average. Using the default settings, this means MACD turns positive when the 12-period EMA moves above the 26-period EMA and negative when the 12-period EMA moves below the 26-period EMA. Thus, MACD, in its purest form, is simply a trend indicator that identifies moving average crossovers. The chart below shows Accenture with MACD turning positive  (uptrend) and negative (downtrend). Notice that the EMA crossovers coincide with MACD crossing the zero line. 

MACD as a Momentum Indicator

The convergence and divergence of these moving averages captures the momentum aspect of MACD. The chart below shows Medtronic with four different combinations. The first two examples show MACD moving from uptrend to downtrend (positive to negative). First, the positive difference between the two EMAs is narrowing when MACD is in positive territory and falling. This means upside momentum is slowing, but the trend is still up. Second, the negative difference between the EMAs is widening when MACD is in negative territory and falling. A downtrend with increasing downside momentum is the most bearish combination for MACD. 

The next two examples show a move from downtrend to uptrend (negative MACD to positive MACD). First, the negative difference between the two EMAs is narrowing when MACD is in negative territory and rising. This means downside momentum is slowing, but the trend is still down. Second, the positive difference between the EMAs is widening when MACD is in positive territory and rising. An uptrend and increasing upside momentum is the most bullish combination for MACD.  

Beware of Trends that are Simply Slowing

The momentum aspect of MACD is a double-edged sword. Decelerating momentum seems to warn of a an impending trend reversal, but does not always result in an actual trend reversal. The chart below shows Microsoft with MACD and the MACD signal line, which is a 9-period EMA of MACD. First, notice that MACD surged in July when the stock surged over 20% and then plunged in August when the stock traded flat. This is typical for momentum oscillators because they gravitate towards the centerline during a consolidation or flat trading period. This can be expected because momentum is essentially flat during a trading range. Thus, a surge-plunge sequence in MACD is not always bearish because a consolidation after a sharp advance is just a rest designed to alleviate overbought conditions. 

Looking further down the chart, Microsoft traded flat into October and then resumed its advance with a gap. Again, MACD surged as upside momentum accelerated and then fell back as momentum decelerated the next five weeks.  Upside momentum in late November was not as strong as in late October, but MACD was still positive and the trend was still up. The same thing happened in December as MACD surged, fell back and flattened. Again, upside momentum in February was not as strong as in December, but the trend was still up and decelerating momentum did not derail the uptrend. 

Keep the Big Trend in Focus

Chartists must also analyze the actual price chart to put MACD signals into perspective. MACD, after all, is just an indicator and indicators are secondary to price action. The chart below shows Abercrombie & Fitch (ANF) breaking down in May with a move below support and the 200-day SMA. The long-term trend was clearly down at this stage and this means chartists should ignore bullish signals. In other words, do not fight the bigger downtrend. Even though MACD turned positive from mid July to late August, a look at the price chart revealed a bounce back to broken support, which turned into resistance. ANF was just retracing a portion of the prior decline with a counter-trend bounce. 

MACD fell sharply when ANF plunged in late August and then started moving higher in October. Downside momentum decelerated and MACD even edged into positive territory in late November. The move into positive territory was not a robust signal because the bigger trend was down. Conversely, the subsequent moves back below zero were robust signals (gray oval) and foreshadowed a move to new lows in the stock. 

Qualify Signal Line Crossovers

The signal line crossover is by far the most prevalent signal - and the most dangerous. MACD can cross its signal line at the high end of its range, at the low end and in the middle. This means signal line crossovers should be qualified with other chart information. At the very least, chartist should consider signal line crossovers when MACD is near the centerline (zero line), not when MACD is at extremes. Consider bearish signal line crossovers when price is below the 200-day moving average and MACD is near the zero line. Consider bullish signal line crossovers when price is above the 200-day moving average and MACD is near the zero line. 

Conclusions

MACD and other momentum indicators can add value to the analysis process, but chartists must first understand what they are implying and when to ignore signals. Decelerating upside momentum does not always lead to a sustainable trend reversal. Similarly, decelerating downside momentum does not always reverse the downtrend. Even crosses of the centerline should be viewed in context with the bigger trend. In short, chartists should focus on robust bullish signals when the bigger trend is up and robust bearish signals when the bigger trend is down. Ignore the rest! 

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Thanks for tuning in and have a good day!
--Arthur Hill CMT

Plan your Trade and Trade your Plan
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