by Wayne A. Thorp, CFA

Moving averages are the easiest and most popular technical indicators. But they are trend-following indicators that work best in strong trending periods; in fact, moving average trading systems tend to lose money during periods of choppy trading.

Since markets and individual securities will, at some point, enter a period of sideways or choppy trading where prices move up and down without any sense of direction, you may want to turn to an indicator that is more sensitive and responsive to that kind of trading behavior. Oscillators fit this bill.

Technicians use oscillators in a variety of waysto determine overbought and oversold conditions, to determine the momentum of a security or index, as well as to identify divergences between price and the indicator.

This article focuses on one indicator that combines the best of both worldsthe trend-following characteristics of moving averages, and oscillator characteristics that help indicate whether a security is overbought or oversold and that help pinpoint potential divergences. The indicator is called moving average convergence/divergence, more commonly known as MACD.

Calculating the macd

The MACD is a trend-following momentum indicator developed by Gerald Appel that shows the relationship between two moving averages of price (normally the close). The MACD line is calculated by taking the difference between a longer-period and shorter-period exponential moving average. It is the interaction of these two moving averages that gives the indicator its name. Over time, the two moving averages are constantly converging and diverging. Exponential averages are used because they respond more quickly to changes in price, since more weight is placed on the most recent price compared to the earlier prices. [For a refresher on the calculation and uses of moving averages, see An Intro to Moving Averages: Popular Technical Indicators in the August 1999 AAII Journal]. A signal or trigger line is also used, which is the nine-period exponential moving average of the MACD line.

Table 1 illustrates the MACD calculation used here. Two items, however, should be noted:

• First, you can use any length of period you wish when calculating the various exponential moving averages, although the 12-, 26-, and nine-period averages are most frequently used.
• Second, a period can be any length you choosedays, weeks, months, etc. In the examples used here, the MACD line is calculated using the 26- and 12-week moving averages, while the signal line is a nine-week moving average of the MACD.