Wide & deep: The scope of MACD

October 30, 2016 09:00 AM
The power of moving average convergence-divergence (MACD) is its versatility, and its versatility comes from its application across numerous market environments.

As we saw in the first installment of this series on moving average convergence-divergence, MACD is more than the sum of its parts, which essentially amount to a couple moving averages. The intricacies of how the indicator is put together make it useful in a number of different ways. The histogram is one such feature.

For more on the mathematical construction of MACD, see “MACD: The Trader’s indicator,” October 2016, Modern Trader). 

As a reminder, the histogram is a visual representation of the relationship between the moving average and its signal line. Its movement, the velocity of its movement and its positioning relative to other elements of the chart are all important in reading the market correctly.

For example, the sooner the fast average crosses the zero line and then enters the histogram, the more in agreement traders are with market synergism and the more sustainable the move is going to be. The fast average best displays trader activity. If you intend to use the MACD efficiently, it is critical that you understand the fast average as it interfaces with the histogram and its relationship to the slow average.

Fast & Slow

Essentially, if the fast average interacts with the beginning of the histogram, and if it can stay close to the outside of the histogram and pull the histogram along with it, the move is going to be not only sustainable but also strong. What this means is that the sooner the fast average can cross the zero crossover line after the new histogram has started, the more likely traders will drive the price action.

When the fast average crosses the zero line at the start of the histogram, it produces a prime probability signal that is nearly 95% accurate in predicting a strongly expanding move. This also provides a decent execution signal if you were not already in the market. The thing to keep in mind is that the histogram basically reflects the synergism within the move, and the moving averages reflect the trader’s actions.

The slow average is how the thrust of the cautious traders is displayed by the MACD averages. Nevertheless, it is critical that you understand the slow average as it interfaces with the fast average if you intend to use the MACD effectively. Anytime the slow average enters the histogram close to the fast average, you are likely to see the move continue strongly (see “Strong basis,” below). The closer the slow average is to the fast average when it enters the histogram, the stronger the upcoming move is likely to be because you are seeing a consensus between the cautious and the short-term traders.

With the fast average in early and the slow average in late, it is an indication that while the short-term traders may be chasing the bus, the more cautious traders do not agree (see “Split decision,” below). 

In fact, about 65% of the time, the move is probably going to reverse close to where the slow average enters the histogram. Nonetheless, there is always the 35% possibility that the move will continue to expand. If it does, the slow average will then bury itself in the histogram. 

Many times, the fast average does not enter the histogram until well after the move’s synergism has nearly exhausted itself. When this happens, the price action usually produces a move that is inherently weak. What is important here is whether the fast average crosses the zero line well after the start of the histogram. How late the fast average enters the histogram is usually indicative of how much synergism there is going to be left for the move to continue. Often times, it takes most of the synergism present just to get the price action to this point. At the same time, the slow moving average should be observed closely because it indicates the tone of the larger market.

In approximately 65% of all incidences, the slow average will regularly indicate the conclusion of the move. Nevertheless, it is always a good idea to check other oscillators and not depend on the slow average for direction. Moves often test on the entry of the slow average into the histogram.

When the slow average is far removed from the start of the histogram, the chart is indicating possible problems with staying in a position. Slow averages entering late, when accompanied by the fast average also going in late, usually indicates the extreme of the present move. In this scenario, we can assume that the concluding move has completed and that the market begins to develop a short (see “Late bloomer,” below). 

The slow average is much better used as a heads-up to get out of the concluding move, as opposed to using it as an entry signal in this case.

Pushing & Pulling

Those who view the MACD oscillator superficially usually fail to look beyond the two moving averages. However, while the MACD is based on an envelope created by two moving averages, it really starts to shine once the averages produce the histogram. The averages and the histogram have distinct functions, and you must always evaluate the MACD’s prognostic ability as being divided between the two. The histogram defines the synergism present in the instrument being traded. More important, it is a determining indicator about what is going on inside every instrument being traded.

As the moving averages are displayed in conjunction with the histogram of the MACD, notice that there are only one of two types of price action present. Essentially, the fast (or signal) average either pushes or pulls the histogram. 

It is essential to identify where the histogram crosses the zero line and where the moving averages enter the histogram, as well as if the fast average pushes or pulls the histogram.

A pushing MACD is a weak move that occurs when the fast moving average enters the histogram late after it has crossed the zero line. With a pushing MACD, the fast average is buried in the histogram and appears to push the bars of the histogram in the direction of the move. This indicates a market where expectations exceed the actual price action. 

For instance, say that you are day trading the E-mini S&P 500 using a one-minute chart and your histogram crossed the zero line at 9:30 a.m., but the fast average does not enter the histogram until 10 a.m. In this scenario, the move will be pushing and weak (see “Weak hand,” below). Pushing moves are often range-bound and therefore are normally only good for a few handles. So it is often a good idea to take your dollar off the table when you can.

A pulling MACD occurs when the fast, or signal moving average, prints outside of the histogram soon after it crosses the zero line, and then flanks the outside of the histogram and visually pulls the histogram along with it. This indicates traders are out-pacing the market’s synergy. When you see this, the price action is going to continue to expand.

For instance, let’s again assume our E-mini day-trading scenario, and the histogram crosses the zero line at 9:30 a.m. The fast average then crosses the zero line at 9:33 a.m. In this scenario, the fast average will probably flank the histogram, and the move will be pulling. In other words, the traders are calling the tune (see “Tracing steps,” below). The important thing to remember is that a pulling MACD is displaying price action that should never be faded.


Keep it in Context

Because the market is always subject to exogenous change, on rare occasion what may start out as a pushing MACD may convert into a pulling MACD if unexpected volume hits the market. Therefore, when trying to backtest this behavior or observing it historically, be aware that even when the MACD starts out weakly, if more traders join in the move, the synergism increases. At this time, the indicator may begin to reflect the increase in trading volume and change the histogram. Of course, this occurs after the fact, and you can end up with what started out as a pushing move self-adjusting into a pulling move and changing your outlook. 

Learning to read the subtleties in the MACD on a short- and long-term time frame may take some time, but will offer great benefits to your trading going forward.

About the Author

Bill DeBuse has been engaged with the markets since 1959 and is presently a proprietary trader for a family foundation.