Moving Average Convergence Divergence MACD

The moving average convergence/divergence (MACD) indicator combines some of the principles of oscillators, like those already discussed, with a dual moving average crossover approach. It uses two metrics, both represented with lines. The faster of the two lines (called the MACD line) is the difference between exponentially smoothed moving averages of closing prices; the 12- and 26-day moving averages are most commonly used. The slower of the two lines is the exponentially smooth average of the trailing nine MACD periods. These metrics can be adjusted, but they are the most common examples and are used by a majority of traders.

There are two ways in which traders use MACD to generate buy and sell signals. The first involves a classic moving average crossover event. When the MACD line, the faster of the two, crosses the signal line, a signal is generated. If the MACD crosses and becomes higher than the signal line, this is a buy signal; if the MACD line crosses and becomes lower than the signal line, this is a sell signal. The second way that MACD gives buy and sell signals is as an oscillator. MACD fluctuates above and below a zero reading. Similar to RSI, when MACD is well above its median position—for this indicator that is zero—the position can be considered overbought. An oversold condition exists when the lines are too far below the zero median. Used in conjunction, the two indicators contained within MACD can be very powerful.

Figure 7.6 shows the chart of a stock's movement as compared to the MACD indicator.

Two important observations can be made from the graph. The first is that in most cases, when the MACD line crosses the signal line, a price reversal occurs. The second observation, perhaps a subtler one, is that the magnitude of the price move that follows a reversal tends to be proportionate to the distance MACD is from zero. In cases where MACD is well above or below zero, representing an oversold or overbought condition, the price move that follows the reversal tends to be larger in magnitude.

As was the case with both RSI and stochastics, a divergence may occur between the price action of the stock or index and the indicator itself. Such a case is represented in Figure 7.6. A divergence of this kind occurs when the MACD lines shift direction and the price action continues. These observations usually signal a more significant reversal pattern in the near future. In fact, this type of indicator divergence is often associated with either a major top or a major bottom, depending on whether the divergence is bullish or bearish in nature.

Convergence Trading
FIGURE 7.6 Moving Average Convergence/Divergence Indicator

VOLUME AS AN INDICATOR

The use of volume as an indicator can be applied to all types of markets and all types of securities. It is usually referred to as a secondary indicator because it must be placed in the context of some other market information to have any practical application. A trader may know that the daily trading volume of a particular stock is climbing, but without any market context behind it, this information is useless. When volume trends are used as a backdrop for other information, however, they can be used as confirmation of another indicator.

Generally, the level of volume is used to measure the intensity of the action observed in a price move within the market. What is relevant to a trader is not the absolute level of volume but the relative trend it displays within a specific time frame. If volume is increasing during an observed price event, the intensity of the move is confirmed by the market's growing conviction in its continuation. It is important to remember that regardless of what other traders may think or say, a technical trader is only concerned with what they do; increasing volume confirms that regardless of previously stated opinions, a growing number of market participants are getting behind the price move and driving it to a larger degree. Of course, if a trader observes declining volume behind a price move, this signals to him that there is not much conviction behind the move and interest is tapering.

Increasing or decreasing volume, and the strength of belief in the price movement that it represents, indicates market pressure to the trader. When a stock is in an upward trend and volume is increasing, there is upward pressure on the stock as more individuals compete to become part of the trend. Conversely, with the same upward-trending stock, if volume is decreasing, there is downward pressure on the stock, as sellers must accept lower prices in order to close their positions. Implicit in this argument is the fact that volume movement tends to precede price movement. This is a result of the fact that the changing number of traders interested in the stock creates the price pressure just described.

The same factors apply to a stock that is in a downtrend. If increasing volume is observed in a down-trending stock, the technician confirms the strength of that trend and believes it will continue. In simpler terms, volume should increase or expand in the direction of the prevailing price trend. When volume decreases in the direction of the prevailing price trend, this suggests that a reversal may occur in the near future.

Figure 7.7 shows the chart of a common stock and the daily volume measurement that corresponds with each trading day's price action. A careful examination of the chart shows that preceding most changes in the price trend of the stock, volume began to decrease or contract. After the reversal occurred, the volume began to increase or to expand in the di-

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2710 1 152912261024 7 224 194 18 18 22 6 20 3 17 1 15391226 3 23 7 21 A 18 2 1630132710241024 FIGURE 7.7 Daily Volume Measurement rection of the new trend. It should not be assumed that simply because one observes falling volume, a reversal is imminent. What can be assumed is that when the technical trader has applied other indicators to the stock he is considering, volume may be used to help confirm whether his analysis is accurate. A trader may believe that a reversal is coming, but the increasing volume he observes in the direction of the trend will cause him to question his analysis and consider other factors. As with any indicator, volume is not a perfect predictor of future price action; when used as a secondary indicator, however, it can help a trader strengthen or weaken his comfort level with the signals provided by primary indicators.

CONCLUSION

This is not a book on technical analysis; readers who require more information are encouraged to find a more comprehensive source.

The indicators discussed in this chapter are but a few of the thousands being used every day by traders in all arenas. There are indicators that are specialized for trading certain types of securities and those designed to be superimposed on others. The indicators considered here are the ones most necessary to a discussion and understanding of pairs trading. In the next chapter, the techniques for applying these indicators to matched pairs trading are discussed and placed in context.

CHAPTER 8

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