Greetings, fellow Pro-fundity team members -
5-21-99 Page

This week's Editorial Guidepost:

1. We have devoted recent Guideposts to technical analysis. Last week we considered the Wilder's RSI Oscillators as a means to identify overbought/oversold conditions. This week we will discuss a trend-following indicator that also subs as an oscillator, providing advantages from both arenas. The MACD (Moving Average Convergence/Divergence) is a trend-following oscillator showing the relationship between two moving averages of prices. As it was designed by Gerald Appel, the MACD is the difference between two exponential moving averages, 26 and 12-day MA’s. As I have played with the MACD with more volatile rolling stocks, I have found what works best for me is a 20-day exponential MA with a 10-day MA. You may find a combination that works better by spending time playing with indicators (this is a lot more fun than chat-boards and video games). Another 9-day exponential moving average of the MACD, not price, is called the “signal” line and is plotted on top of the MACD to show buy/sell opportunities. (Again, my choice is a 6-day exp. MA)
2. The MACD is most effective in volatile trading markets as opposed to long term trends. This indicator maintains value as a trend-follower being created from moving averages, however, it has the added benefits of an oscillator. There are two important ways to use the MACD, as an overbought/oversold identifier and by spotting divergences.
3. Lets first see how the MACD is calculated. The chart below shows a recent pick with a consistent rolling pattern. We will first plot on this chart the “long” moving average (rather than Appel’s 26 day MA, we use a 20-day MA).
BTGC Price Bar Chart with 20-day exp MA
4. Remember from our discussion of Moving Averages, when the MA line crosses the price pattern, a signal is generated: Sell when it crosses up, buy when it crosses down. We can see how these signals lag the action with the moving average.
5. Next place a shorter 10-day MA on the same price chart to see how the signals arrive in a more timely manner (less lag).
BTGC Price Bar Chart with 10-day exp MA
6. This pictures show the signals coming with less lag, improving our bottom line. The down-side to the faster action is the danger of false signals, leading to whipsawing. Remember, for each advantage we gain, we give up something elsewhere: “TANFL” (there ain’t no free lunch).
7. Now try these two moving averages together on the same price pattern, as shown below. It is easier to see how the longer term (red) MA is a more stable, more smooth rendition of where the price chart is going, while the shorter MA (blue) is more sensitive to price changes and hugs the price pattern more closely.
BTGC Price Bar Chart with both MA’s
8. Nothing jumps out at us from this chart, but next consider what a line would look like which is the difference between the blue and the red lines. That is, on each day (each bar on the price chart) subtract the Red line from the Blue line. When the Blue is above the Red, this difference will be positive, and negative when the Red is on top. The difference will equal zero when the Red and Blue cross. When we plot these differences in black as shown in the lower frame below, this new line is the MACD.
BTGC Price Bar Chart MACD as the difference between MA’s
9. The MACD line then varies above and below zero. The zero line identifies points where the two MA’s cross, or where they are equal, the difference being zero. This indicator is then an oscillator, moving back and forth above and below some reference line, in this case, the zero line. This identifies overbought and oversold conditions, with positive MACD signaling overbought, negative MACD a signal for oversold.
10. Unlike Wilder’s RSI and the Stochastic, both of which have predetermined overbought and oversold levels, the MACD has no distinct levels to identify these conditions. It is up to us to determine how far above and below zero for a particular stock the MACD provides signals. In the chart above, had we used the MACD peaks for signals, we would have been ahead of the signals generated by the moving averages.
11. The 9-day MA of Appel’s MACD, mentioned above in point 1, is usually plotted on top of the MACD indicator. This “signal” line tells us when the MACD is changing direction. This is a prediction that the two MA’s in point 9 are moving together. This is the same thing as the MACD moving toward zero (we use a 6-day MA for this line).
BTGC Price Bar Chart MACD with the Green signal line
12. The MACD indicator finds wide use as an overbought/oversold indicator. When the shorter blue moving average (the 10-day MA in our case) pulls away from the longer red 20-day MA (the MACD will be rising), the stock price is likely overextending and will soon return to more realistic levels (it is an overbought condition). We would know this by watching when the green signal line crosses the black MACD line.
13. When the MACD is above zero, the shorter blue MA is higher than the longer red MA. This shows that current expectations (i.e., the 10-day MA) are more bullish than previous expectations (i.e., the 20-day MA). This implies a bullish, or upward, shift in the supply/demand lines. When the MACD falls below zero, the opposite is the case. The 6-day MACD MA (signal line) anticipates changes in the MACD direction and is then used as a signal line for action. Point: The only signal we need to watch is the relationship between the MACD black and green lines. We used the red and blue MA’s to calculate the MACD and to understand why it works, but the MACD stands alone.>/LI>

14. The MACD is helpful as an oscillator in that it can signal when a trend reversal is likely. This occurs when the MACD diverges from the stock price. A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows. A bullish divergence occurs when the MACD is making new highs while prices fail to reach new highs. These divergences are most significant at the tops and bottoms of the oscillator pattern.
15. Next week we will consider some examples of MACD divergences while covering On Balance Volume (OBV). With so many indicators to consider, we may feel overwhelmed and simply respond, “If it takes that kind of effort and study, I’m outa here!” Whoa, we’re getting to the best part, where we understand how to use indicators in tandem, based on the situation and the market conditions, which to use when. This is all to make it easier, to require less time. Stay tuned.

16. Study Schedule:

May 28 - On Balance Volume(OBV)

June 4 - Stochastics

June 11 - TC-2000 proprietary indicators (BOP, MS, TSV)

It is our intent to help our readers understand market strategies well enough to make informed decisions and understand the risks.

We provide TC-2000 tutorials to members. See the Member Login page.