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T he moving average convergence-divergence (MACD) originally was constructed by Gerald Appel,an analyst in New York at the time, as a technique for analyzing stock trends.The indicator achieved widespread appli-cation by many traders across all types

of markets. Today, it is one of the mostwidely referenced gauges of the marketstechnical condition.

There is good reason for this. MACDis one of the simplest and most intuitiveindicators available. Over time, it hasdemonstrated a satisfying level of reliabil-ity. While not always perfect, of course,when MACD doesnt signal precise entry and exit points, it usually conveys valu-able information about the general stateof the market bullish or bearish andpoints traders in the right direction.

MACD is constructed by subtractinga longer moving average from a shortermoving average. A moving average is sim-ply the average value of prices over themost recent N days. The shorter averageis believed to be more responsive to pricechanges; the longer average is consideredless responsive. By subtracting the value

of the longer moving average from the value of the shorter moving average, wegenerate the difference. This can be plot-ted by itself below the price chart. Theplot will oscillate above and below zero,with (theoretically) no upper or lowerlimit. In addition to the MACD, the

oscillator chart often includes two otherplots. One is the signal line, which is justa moving average of the MACD itself.The other is a histogram. The histogramis just a visual aid, indicating how far theoscillator is from its signal line.

Traders typically speak of a fastMACD and a slow MACD. For ourpurposes, well consider a fast MACDone that uses shorter moving averages(say, five and 10 periods) to produce a quicker, more responsive indicator. Wellconsider a slow MACD one that uses

longer moving averages (say, 12 and 26periods) to produce a slower indicator,but one that is less prone to false signalsand whipsaw-type action. Most chartingpackages have a default of 12 periods forthe fast-moving average and 26 periodsfor the slow.

MACD remains a viable method foranalyzing both stock trends and identify-ing short-term changes in market trend,particularly in both the overall stock mar-ket and individual stocks.

Understanding MACDFor our MACD, well turn to the 12- and26-day averages. Instead of simple mov-ing averages, well use exponential mov-ing averages (EMA), which are calculatedto reflect prices over the stated period butemphasize more recent values.

A positive MACD is generated whenthe 12-day EMA is trading above the26-day EMA. A negative MACD indi-cates that the 12-day EMA is tradingbelow the 26-day EMA. If MACD is pos-itive and rising, then the gap betweenthe faster moving average (blue) andthe slower moving average (red) is wid-ening (see MACD in the S&P, right).This indicates that the rate-of-changeof the faster moving average is higherthan that of the slower moving average.Positive momentum is increasing, indi-

cating a bullish period for the price plot.Included in MACD in the S&P are the12- and 26-period EMAs. Notice how MACD indicated a buy signal severalbars before a basic moving average cross.

If MACD is negative and declin-ing, then the negative gap between thefaster moving average (blue) and theslower moving average (red) is expand-ing. Downward momentum is accelerat-ing, indicating a bearish trading period.MACD centerline crossovers occur when

One of the simplest and most easily analyzed technical indicators,

MACD has a number of applications that help you initiate stock trades.

Trading stocks with MACDBY BRAMESH BHANDARI

TRADING TECHNIQUES

E Q U I T I E S

32 FUTURES December 2011

Directional indicators

Divergence & crossovers

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the faster moving average crossesthe slower one.

Bullish/bearish signalsThere are a number of bullish sig-nals generated by the MACD. They can be broken down as positivedivergence, a bullish moving aver-age crossover and a bullish center-line crossover.

A positive divergence occurs whenMACD begins to advance and theindex or stock is still in a down-trend and makes a lower reactionlow. Positive divergences probably are the least common of the threesignals, but usually are the most reli-able, and lead to the biggest moves(see Technical divergence, right).

A bullish moving average cross-over occurs when MACD movesabove its signal line (in this case, a nine-day EMA). Signal line cross-overs are the most frequent signalsgiven by the MACD (see Signal linecross, page 34). If these arent usedin conjunction with other technicalanalysis tools, the trader followingthem can fall victim to numerousfalse signals.

The bullish centerline crossover is

another somewhat common occur-rence. This signal is generated whenthe MACD moves above the zeroline and into positive territory (seeBull move, page 34). It tells us thatprice momentum has changed frombearish to bullish.

The mirror of the bullish signalscan be used to identify potentialbearish turns in the stock mar-ket. These are known as negativedivergence, bearish moving averagecrossovers and bearish centerline

crossovers. As with bullish divergence, nega-

tive divergence is the most subjec-tive of the three common bearishsignals. Negative divergence formswhen the index or security advancesor moves sideways, and the MACDdeclines. Negative divergence inMACD can take the form of eithera lower-high or a straight decline.Negative divergences probably arethe least common of the three sig-

futuresmag.com 33

Source: eSignal

Source: eSignal

The late-August cross of the MACD histogram into positive territory is a stellar example ofthe indicator forecasting a strong trend in the S&P 500. Also notice how MACD indicated abuy signal several bars ahead of a simple moving average cross.

When MACD moves higher (or lower) and the price of the stock or index fails to respond,

this is known as divergence and indicates a potential price move, as shown here in theNasdaq Composite.

MACD IN THE S&P

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MACD histogramMACD minus the MACD signal link

Positive divergence in Nasdaq observedwith index making lower lows andMACD making higher highs

MACD 12-period EMAminus 26-period EMA

MACD signal Line9-period EMA

S&P 500

Nasdaq Composite

Signal

signal

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nals, but usually are the most reliableand can warn of an impending peak(see Before the fall, right).

As on the bullish side, the morecommon signals are the bearish mov-ing average crossover and the bearishcenterline crossover. A bearish mov-ing average crossover occurs whenMACD declines below its signal line. A bearish signal line crossover occurswhen MACD moves below its zeroline and into negative territory; thisis a clear indication that momentumhas changed from bullish to bearish.Often, a centerline crossover can actas a confirmation of either a movingaverage crossover or negative diver-gence. In any case, once MACD cross-es into negative territory, momen-tum, at least for the short-term, hasturned bearish.

Of course, all of these analysisapproaches can be modified in a number of ways. For example, youmight place different weight on sig-nal line crossovers that occur in posi-tive or negative territory, or thosethat occur at recent extremes in theMACD itself. Strengths & weaknesses

The primary strengths of MACD arethat it incorporates aspects of bothmomentum and trend in one indi-cator. The use of moving averagesensures that the indicator eventu-ally will follow the movements of theunderlying security.

As a momentum indicator, MACDhas the ability to foreshadow movesin the underlying index or security.For example, MACD divergencescan be key factors in predicting a trend change. The effectiveness

of the MACD will vary for dif-ferent securities and markets. Aswith all indicators, MACD is notinfallible and should be used inconjunction with other technicalanalysis tools, such as trendlines, volatility measures or cycle analysis.One of the beneficial aspects of theMACD also is one of its drawbacks.Moving averages, be they simple,exponential or weighted, are laggingindicators. Even though the MACD

TRADING TECHNIQUES continued

34 FUTURES December 2011

Source: eSignal

Source: eSignal

The red signal line is an EMA of the MACD plot. When the MACD moves above it, it is con-sidered a bullish development, as shown here with Apple. As you can see in the indicatorplot, crossovers are common and can give frequent false signals.

When MACD went positive, IBM responded with a solid short-term rally.

SIGNAL LINE CROSS

BULL MOVE

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MACD moving above 9 EMA lineand Apple starts its BULL run

MACD going abovezero line; IBMgaining positivemomentum

Apple Inc.

IBM

Signal

Signal

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TRADING TECHNIQUES continued

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represents the difference between twomoving averages, there still can besome lag in the indicator itself. This ismore likely to be the case with weekly charts rather than daily.

Some traders avoid the MACDbecause it has achieved widespreaduse in the markets. Perhaps familiarity has bred contempt or they believe thatthe indicators signals are discountedby the markets. You may believe this isso, but base it on first-hand experience,not assumptions or unproven biases.Of course, if an indicator isnt workingfor you, move on. But for most stocktraders, MACD can point you in theright direction. It shouldnt be youronly tool, but its definitely one worthkeeping at the ready.

Bramesh Bhandari trades the Indianstock market and teaches technical anal-ysis to traders. He can be reached at:bhandaribrahmesh@gmail.com. Source: eSignal

JP Morgan initiated a steady and prolonged decline in early to mid-2011. This was pre-ceded by a clear negative divergence between price and MACD.

BEFORE THE FALL

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JP Morgan moving up butMACD forming lower-highformation and negativedivergence, and JPM downto $39 from high of $48.

JP Morgan Chase & Co.

MACDSignal

Trading Techniques: Kmiecik continued from page 31

options get closer to expiration, the delta on the spread will widen. However, thegoal of the trade remains the same: Forthe stock to trade over the sold callsstrike by December expiration.

Bearish scenario

A bear put spread (bearish vertical debitspread) involves buying a put option andselling a lower strike put. The maximumgain on this spread is the difference in thestrike prices minus the cost of the trade.The most the option trader can lose is the

cost of the spread.Its Oct. 25 and ZZZ stock is trading at

$318.50 a share. An option trader believesthe stock is overbought and might declineover the next month. The options are pret-ty expensive, and the trader worries thatthe stock might keep rising, so a bear putspread makes sense. The trader can buy the November 315 put (just OTM) witha current delta of 0.44 for $9 and sell theOTM November 305 put with a currentdelta of 0.28 for $5.25. The cost of the

spread is $3.75 ($9 $5.25), which is themost the trader can lose if the stock fin-ishes above $315 by November expiration(see Bear put debit spread, page 31).

The maximum profit potential on thetrade is $6.25 ($10 - $3.75), which is thedifference in the strikes minus the costof the trade. This would be achieved if ZZZ finished below $305 at Novemberexpiration. Breakeven on this trade canbe calculated by subtracting the costof the trade from the long puts strikeprice. In this example, its $311.25 ($315

- $3.75) at November expiration. Just likewhat was shown in the bullish example,if the November 315 put were boughton its own, the breakeven on the tradewould be $306 ($315 - $9), which is quitea bit more.

Currently, the delta on the spread is0.16 (0.44 - 0.28), which means the tradewill make or lose 16 for every dollarthe stock goes up or down. Again, thiscan be a disadvantage, but if the stockrallies even more, which was one of the

concerns, the trader will lose less on thespread than by just being long the puts.The maximum profit goal of the bear

put spread is to have the stock tradingbelow the sold puts strike at Novemberexpiration.

Vertical debit spreads are a relatively easy to understand and pretty straight-forward option strategy. Just like any other option strategy, each has advan-tages and disadvantages. When decidingwhether to buy just calls or puts, or tobuy a vertical debit spread, the pros and

cons of each have to be debated. Often,however, this analysis will come down onthe side of the spread. With this strategy in your arsenal, you now can be preparedfor those times.

John Kmiecik has worked for several firms,

including Goldman Sachs and First Options

of Chicago, and has traded professionally

for hedge funds. Currently, he is an options

coach for Market Taker Mentoring LLC.

E-mail him at john@markettaker.com.