Chart 1: The Nasdaq Composite Index and its MACD

Determining Bullish Signals with MACD

The most basic way to read the MACD is that positive momentum is considered to be bullish. That is, when the 12-day EMA is trading above the 26-day EMA, a positive MACD results and the black line is above zero. If it is positive and rising, then the gap between the two EMA's widens, indicating the rate of change of the fast line is higher than that of the slow line. This results in positive momentum.

Bullish signals are derived from MACD through the bullish centerline crossover, the bullish moving average crossover or positive divergence.

The most basic bullish signal occurs on a positive centerline crossover which takes place when MACD moves above the zero line, indicating momentum has changed from negative to positive or from bearish to bullish. All the centerline crossovers, bullish and bearish, can be seen as vertical blue lines in Chart 1.

Moving average crossovers, highlighted by vertical red lines, occur when MACD crosses path with its 9-day moving average, the slow line. When the MACD moves above the slow line it is called a bullish moving crossovers. While they are the most common and frequent signal triggers, moving average crossovers are also the least reliable.

The most accurate bullish MACD signal is a positive divergence which arises when MACD is advancing while the security is still in a downtrend. In Chart 2 below, the blue lines clearly show the divergence between the Nasdaq Composite Index price, which was still setting new lows during late April 2005, and its MACD which was already in an uptrend.

An additional gem to be found on the chart is the MACD histogram, pictured as vertical bars originating from the zero line, going up or down. They represent the difference between the 26- and 12-day EMAs in a way that instantly shows the momentum, its direction, and if it is increasing or decreasing. Some say MACD is more useful as a momentum gauge than as a source of market direction change signals.

Chart 2: MACD positive divergence

While these divergences and crossovers are intellectually stimulating and may accurately represent the market, they also frequently lead to whipsaws and false signals. One reason is because the MACD represents the difference between two moving averages - and moving averages are lagging indicators. Thus the indicator itself also lags. There can also be long periods of time, when markets are choppy or range bound for example, during which the MACD and its trigger line remain in close proximity and intersect frequently. This even happens during prolonged trends, when the two lines will tend to hug the zero line.

Another aspect of MACD that makes it less reliable is its lack of upper or lower limits. With nothing to bind its movement, MACD can overextend beyond historical extremes so that it cannot reliably identify overbought and oversold levels.

Finally, the effectiveness of MACD varies for different securities and markets. It is a tool that should not be relied upon solely to predict market change and trigger buy/sell decisions.

Because of these weaknesses, the TimingCube Model does not look at MACD in any way. In contrast, its proven methodology minimizes the potential whipsaws and false signals that MACD often hazards.

Warm wishes and until next week.

The TimingCube Staff