Does Moving Average Convergence Divergence (MACD) work?

Saturday, Nov 10 2012 by
5
Does Moving Average Convergence Divergence MACD work

As part of a series looking at technical/momentum indicators, today we're going to look at MACD.

Developed by Gerald Appel (publisher of Systems and Forecasts) in the late seventies, the rather grand-sounding "Moving Average Convergence-Divergence (MACD) indicator" is actually one of the most commonly used momentum indicators around. It is used to spot changes in the strength, direction, momentum, and duration of a trend in a stock's price. 

What is MACD? 

The MACD is just the difference between a 26-day and 12-day exponential moving average of closing prices (an exponential moving average or EMA is one where more weight is given to the latest data).  A 9-day EMA, called the "signal" (or "trigger") line is plotted on top of the MACD to show buy/sell opportunities. 

 

Why is the MACD useful?

The reason that traders pay attention to varying lengths of moving averages is because they want to figure out how the short-term momentum is changing relative to the longer-term momentum. If the short-term average rises faster (slower) than the long-term average, the MACD moves upward (downward). Traders use this to suggests that the buying pressure is increasing (decreasing). 

Interpretation

One of the reasons that MACD is so popular is because its trading signals are fairly unambiguous. You can see a good video introduction to its usage here but, in summary, there are three popular ways to use the MACD: crossovers (signal line or centre-line), overbought/oversold conditions, and divergences.

1. Crossovers

a) Signal Line Crossover - The basic MACD trading rule is to sell when the "slow line" of the MACD falls below the faster 9-Day EMA line (known as a "signal line crossover") and similarly, a buy signal occurs when the MACD rises above its signal line. 

b) Centre Line Crossover - It is also popular to buy/sell when the MACD goes above/below zero (known as a "centreline crossover"). Great momentum stocks stay above zero for a long period of time. Cross overs below zero are usually be ignored since the stock is weak and it is said that trends can not be predicted as easily.

2. Divergences

Crossovers happen quite frequently. Another signal, considered more reliable but less frequent, is a pattern called bullish convergence. This is where the market price itself makes a lower low from a previous low but the  underlying MACD pattern makes a higher low. This indicates that the low is weak or a “false” bottom and can resort to a turn around for a price reversal. In his book, Trading for a Living, Alexander Elder calls price divergence with the MACD, “the strongest signal in technical analysis.” A bullish divergence occurs when the MACD is making new highs while prices fail to reach new highs. Both of these divergences are most significant when they occur at relatively overbought/oversold levels. Even here, however, false signals are commonplace ("a divergence takeout"). Prices might have several final bursts up or down that trigger stops and force traders out of position just before the move actually makes a sustained turn and the trade becomes profitable. 

3. Overbought/Oversold Conditions

Generally, the MACD is not used as an overbought/oversold indicator because the MACD is unbounded (the MAs can continue to diverge). When the shorter moving average pulls away dramatically from the longer moving average (i.e., the MACD rises), it might be argued that the price may be overextending. However,  it is more common to use the MACD in combination with range-bound indicators like the RSI or the Williams %R

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Problems with MACD

One issue is that the MACD is a lagging indicator. Because it uses moving averages and moving averages lag price, the signal it provides can come late (the price may have reached the reversal point already before the entry signal is generated). The same can be true for exiting positions.

To try to address this, MACD charting is usually accompanied by the MACD histogram. Developed by Thomas Aspray in 1986 to anticipate signal line crossovers in MACD,  this is a visual representation of the difference between the MACD and the signal line (the nine-day EMA). The histogram is positive when the MACD is above its nine-day EMA (and negative when the MACD is below). Bullish or bearish divergences in the MACD-Histogram can alert chartists to an imminent signal line crossover in MACD. 

Another important point to remember is that the MACD is regarded as most effective in wide-swinging trading markets, just like any moving average crossover. Its weakness is that, when the market is trendless, the MACD tends to generate lots of false / unprofitable buy and sell signals.

Does MACD Trading work?

As with most technical indicators, there is some evidence that it does (but not much!). Terence Chong of the University of Hong Kongapparently tested MACD over a 60 year period on the UK stock market and found evidence of it being able to produce higher returns than a buy and-hold strategy.

However, Albin, Gunter and Kai did some comprehensive testing of the MACD signal for NASDAQ-100 stocks over a 10-year period. They found that it had a surprisingly low success rate of 32.73%, i.e. worse than blind chance and almost a contrarian indicator! This was mainly because its short-term nature lead to traders being whipsawed in and out of a position several times before being able to capture a strong price movement. They did come up with several refinements, known as MACD R1 & MACDR2, which substantially improved the odds.

MACD R1 - This attempts to ignore buy and sell signal if crossovers are too intensive in a short period of time. To accomplish this, the trading signal is only given three days after the crossover, provided that no other crossing has appeared in between. To overcome the lack of e a timely exit warning, they also set a predetermined target at 3% or 5% for profit taking (although the flip side of setting a predetermined profit level is that a system might miss out the greater profit potential in a steady long trend).

MACD R2 - This uses the same trading rules from MACD R1 but, in addition,  there must be a pre-determined "trigger level" difference between the signal line and MACD which is greater than a percentage  of the stock price. Their work tested crossing levels from 0.5% to 3.5% (above 3.5%, hardly any trading signals occur). Gunter et al claimed that with this extra factor, MACD R2 is able to capture a more significant trend in the beginning by avoiding random movement in a narrow trading range. Unfortunately, a subsequent paper, "A Test of the MACD Strategy " by Huang found that, with these adjustments, MACD trading could outperform buy-and-hold if trading costs were ignored - but the results did not hold once they were included. 

How can I use this filter?

You can run a MACD filter here using our charting tool - we're also planning to add the following events as part of our stock filter screening. You can sign up for a free trial here.

  • MACD Bullish Divergence (Bearish Divergence)
  • MACD Crossed Above /  Below Signal Line
  • MACD Crossed Crossed Above / Below  Zero
  • MACD-Histogram Turns Positive (& MACD negative to insure this upturn occurs after a pullback). 
  • MACD-Histogram Turns Negative (& MACD positive to insure this downturn occurs after a bounce). 
  • MACD histogram greater than 2 (or less than -2)
  • MACD Histogram Consecutive day movement

These events would usually be considered in light of other confirmatory signals, eg. stocks trading above their 200-day moving average, which implies an uptrend overall.

Conclusion

Opinions are sharply divided on the value (or otherwise) of MACD. Anecdotally, traders do suggest that it is useful for trading trends, because it shows the (increasing and slowing) momentum of a movement. Jeff Hochman, Fidelity Investments notes that, "when I see a monthly MACD crossover that does not occur very often, say every few years, I pay attention" while Robert Colby in his “Encyclopedia of Technical Market Indicators” says that MACD backtesting shows that the indicator is most effective with longer-term trading strategies but over the short-term, is not profitable. 

Overall, there is relatively little hard evidence that MACD trading on its own can provide reliable alpha, as compared with say the value effect. In part, this may be because of acknowledged deficiencies with a mechanical application of the approach, i.e. as a lagging & short-term nature of the MACD indicator, it can give false triggers, i.e. unprofitable buy and sell signals, especially when the markets / securities are going sideways. Whether modifications of the approach can effectively correct for this is open to debate. It may be that MACD is more effective when used in conjunction with other technical indicators to ensure a more accurate idea about a stock's direction, but again, we've not seen any decent empirical studies to support this claim.

Further Reading


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4 Comments on this Article show/hide all

schober 14th Nov '12 1 of 4
2

1 does it work? of course not otherwise we'd all be rich!
2 can it be made to work? ............ possibly, but not using the default settings on most chart packages
3 you have failed to address optimization, robustness, backtesting, walk forwards testing etc etc - did any of the academics cited go through these processes? if not their results are not surprising
4 if you want to use macd rsi etc you need to read this first
http://www.amazon.com/Design-Testing-Optimization-Trading-Systems/dp/0471554464
pardo gives an account of how to do it - its not for the faint hearted - it needs statistical, maths and programming abilities

5 one problem you omitted is the frequency response of ema's ( and sma's) -theyre easy to calculate but mathematically quite complex

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smarm 28th Nov '12 2 of 4
2

I have been making money from the MACD for about 5 years now but you need to know how to use it. Blindly following every crossover can make money on some stocks in some market conditions, you just have to learn which stocks and which market conditions. However, I would never suggest using crossover on its own.

The real jewel in the MACD crown is divergence (where the price goes one way and the indicator goes the other) but if you look at any momentum indicator e.g. RSI or CCI, they give the same signal just with different timing. I'm always amused when people put up 5 momentum indicators and say "look, all the indicators agree". Well yes, of course they do...they are basically all doing the same thing. Doh!

What I do is use 3 indicators with different timings. I can then either buy in one go on the first signal if the market is strong, or scale in slowly if I'm worried about the timing (hindsight trading is far easier than trading the right side of the chart!). This scaling/timing allows me to make money year in, year out and while it's also about good stock picking, timing and money management have proved more important overall.

My next technical analysis seminar is on Sunday 9th December at a hotel near Heathrow....there are still a few places. I will show you how I trade using recent real trades or very recent charts. No day-trading; this is for would-be Naked Traders who need a little help with their timing. Details under seminar here: http://www.nakedtrader.co.uk/

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smarm 28th Nov '12 3 of 4
2

By way of an example, have a look at FPEO (I hold). The MACD crossed down nearly a month ago and the worry was that the price wasn't going to manage a new high (look back to July 2011) and would retreat back to the 170 area but I didn't sell. Why? Because my other two indicators said that there's absolutely no need. A nice rise today and hopefully a breakout towards the next resistance point at 200p.

Sorry no chart, I am out and about and it's a bit too fiddly to do on the move.

I should add that I am holding FPEO because of their recent statement that they will be paying out 4% of NAV and I do like a nice income play. It's trading at a wide discount to NAV so there's also a good chance of a capital gain if and when the discount closes.  Conservative?  Yes.  Better than sitting in cash?  You bet. 

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Murakami 28th Nov '12 4 of 4
1

Thanks, Smarm - we're setting up some technical stock filtering options at the moment, including MACD, as quite a large number of PRO users have requested this to go alongside the fundamental filters.

At the moment, we're adding chart event tracking for MACD Crossovers, RSI Levels, Golden Cross, Death Cross, & Average True Range - any other suggestions are welcome (either here or preferably via the Green Help & Feedback button).

We've also beefed up the Charting Options here - http://www.stockopedia.com/share-prices/vodafone-LON:VOD/chart/ - to include EMAs and other filters like Chaikin Money Flow.

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