Bullish/bearish signals

There are a number of bullish signals generated by the MACD. They can be broken down as positive divergence, a bullish moving average crossover and a bullish centerline crossover.

A positive divergence occurs when MACD begins to advance and the index or stock is still in a downtrend and makes a lower reaction low. Positive divergences probably are the least common of the three signals, but usually are the most reliable, and lead to the biggest moves (see "Technical divergence," below).

A bullish moving average crossover occurs when MACD moves above its signal line (in this case, a nine-day EMA). Signal line crossovers are the most frequent signals given by the MACD (see "Signal line cross," below). If these aren’t used in conjunction with other technical analysis tools, the trader following them can fall victim to numerous false signals.

The bullish centerline crossover is another somewhat common occurrence. This signal is generated when the MACD moves above the zero line and into positive territory (see "Bull move," below). It tells us that price momentum has changed from bearish to bullish.

The mirror of the bullish signals can be used to identify potential bearish turns in the stock market. These are known as negative divergence, bearish moving average crossovers and bearish centerline crossovers.

As with bullish divergence, negative divergence is the most subjective of the three common bearish signals. Negative divergence forms when the index or security advances or moves sideways, and the MACD declines. Negative divergence in MACD can take the form of either a lower-high or a straight decline. Negative divergences probably are the least common of the three signals, but usually are the most reliable and can warn of an impending peak (see "Before the fall," below).

As on the bullish side, the more common signals are the bearish moving average crossover and the bearish centerline crossover. A bearish moving average crossover occurs when MACD declines below its signal line. A bearish signal line crossover occurs when MACD moves below its zero line and into negative territory; this is a clear indication that momentum has changed from bullish to bearish. Often, a centerline crossover can act as a confirmation of either a moving average crossover or negative divergence. In any case, once MACD crosses into negative territory, momentum, at least for the short-term, has turned bearish.

Of course, all of these analysis approaches can be modified in a number of ways. For example, you might place different weight on signal line crossovers that occur in positive or negative territory, or those that occur at recent extremes in the MACD itself.

Strengths & weaknesses

The primary strengths of MACD are that it incorporates aspects of both momentum and trend in one indicator. The use of moving averages ensures that the indicator eventually will follow the movements of the underlying security.

As a momentum indicator, MACD has the ability to foreshadow moves in the underlying index or security. For example, MACD divergences can be key factors in predicting a trend change. The effectiveness of the MACD will vary for different securities and markets. As with all indicators, MACD is not infallible and should be used in conjunction with other technical analysis tools, such as trendlines, volatility measures or cycle analysis. One of the beneficial aspects of the MACD also is one of its drawbacks. Moving averages, be they simple, exponential or weighted, are lagging indicators. Even though the MACD represents the difference between two moving averages, there still can be some lag in the indicator itself. This is more likely to be the case with weekly charts rather than daily.

Some traders avoid the MACD because it has achieved widespread use in the markets. Perhaps familiarity has bred contempt or they believe that the indicator’s signals are discounted by the markets. You may believe this is so, but base it on first-hand experience, not assumptions or unproven biases. Of course, if an indicator isn’t working for you, move on. But for most stock traders, MACD can point you in the right direction. It shouldn’t be your only tool, but it’s definitely one worth keeping at the ready.

Bramesh Bhandari trades the Indian stock market and teaches technical analysis to traders. He can be reached at: bhandaribrahmesh@gmail.com.