Day and swing trade like a pro.

MACD Trading

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  MACD stands for Moving Average Convergence Divergence. It is a technical trading tool for a day and swing trading.

There are many ways active market participants use this oscillator such as　

1/ right of precedence to bullish signals when the oscillator is above the zero line

2/ and priority to bearish signals when it is below the zero line.

Apart from these basic interpretations and there is an advanced approach when one is analyzing the

indicator. This article will demonstrate to traders how one can analyze the indicator like a professional trader.

The zero line

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20channel.jpg /% The thin dividing line between the bullish market trading zone and the bearish zone when one is using this oscillator is the zero line or the equilibrium line.  To a certain degree, it is a psychological price level or PPL.  When MACD is below the water line or the zero line, it indicates that the price is in a declining channel.  Conversely when it returns above the water line it signals that the price is now in a rising channel.  Most bearish traders will stop selling as soon as it rises above the water line.  The inverse is also true when it dips below the equilibrium line.  Bullish stock traders do not want to trespass the bearish territory, and bearish day or swing traders do not mind staying in their bearish zone.  This is the theory.

Sometimes, the technical oscillator may be lower than the water line, but the financial instrument will already come out of the bearish channel and vice versa.  It is essential to know that one is not trading the moving average convergence divergence itself, but the asset (price).

To put a stop to common trading mistakes, one must always keep eyes on the price or trade it instead of the technical indicator.  Many technical traders cherish their trading tools, and spent a vast amount of time analyzing their tools.

However, most do not align the signals with the three market patterns (rising channel, horizontal channel and declining channel) or do not pay attention to price (the number indicator).  Equally, some traders find it highly challenging to align the theory with the markets environment. Therefore, most end up making irrational trading decisions.  Though the bearish zone is below the water line, it does not imply that it is impossible to buy in it.

If a financial asset becomes oversold in an up trend or at the end of a down trend(or breaks above the declining channel, retests it and turns around), one can buy it.  The purpose of this article is not to write what has already been written about MACD over the years, but to give traders an idea about a different way one can analyze it (a practical approach for using this trading tool).

By studying the oscillator, we also have noticed that when it is higher than the water line, price is usually above the moving average 50 and vice versa. Theoretically, the right moving average, which represents the equilibrium line is the moving average 26 (referring to the standard MACD (12, 26, 9).

The zero line is also an alternative for the relative true value of the financial instrument that one is trading.  It is relative to the time frame one is using. If one is using the hourly chart, and another trader is using the daily chart, the zero line in each case represents the relative true value.  The relative true value on the hourly chart is poles apart from the four hours charts.  In theory, one may say that the price is below its relative true value (RTV) when it dips below the water line.  Note that the relative true value is not inevitably the correct real true value in terms of fundamentals, but just an acceptable technical fair value for active day or swing traders.

Deviation from the zero line or divergence

When the oscillator extremely deviates from the zero line, it is a divergence.  It means the moving average convergence divergence is a multiple times its relative true value (water line).  For example, if the current RTV is 2 but the moving average convergence divergence is 12, it demonstrates that the oscillator is 6 times multiple of its RTV (Relative True Value).  It is overbought.  When an asset is really overbought, it will fix itself until it reaches its equilibrium value.  A divergence is a discrepancy because of the exaggerations or deviations that have taken place.

Most day or swing traders who trade the indicators instead of the asset itself tend to sell as soon as an oscillator reaches the overbought zone.  It is a folly to put it lightly.  They also associate an oversold oscillator to a bullish signal.  There is a wild software out there forcing the market up and down.  It buys every time an oscillator is oversold and sells each time an oscillator tags the overbought region.  One will not dwell on these irrational trading methods, but this will be a topic for future articles.

Does an overbought technical indicator always signify that the asset itself is overbought?

The exact answer is no.  It is not always the case but only occasionally.

If a deviation occurred, one must not overlook it.  One can draw a warning line or highlight the distortion.  In another word, one is aware of the deviation, but now one must investigate to confirm whether the divergence is true or false.

Recognizing a real divergence or deviation

A/ Above the zero line

When a financial asset is more than five times its actual value, but the actual value did not increase (or is not likely to grow in the meanwhile), one may consider it as overbought.  Note that one is comparing the current price to the current true value (not the original real value).  When the original true value is equal to the current real value, but the price is now three or five times the real value, one may divest or bank profit before the asset drops to its fair value.  However, it is essential to highlight that MACD is an indicator, and it is the price or the asset that one is trading.  Therefore, when it is overbought, it is cautioning us about possible true overbought market conditions.  The technical trading tool may be overbought, but the asset may not be.

Looking at the charts below, one will notice that the oscillator diverged from the equilibrium line, alerting us about a possible correction.  Though, the indicator was returning to its relative true value (RTV), the price was not decreasing substantially.  The indicator was overbought, but the price was not.  This is a distinctive false overbought alert. 

A misleading overbought signal occurs when:

1/ a noticeable deviation has taken place (referring to the moving average convergence divergence)

2/ the oscillator becomes overbought

3/ but the price does not because as it was rising together with its original true value either

at the same time, or the same rate.  Though the financial asset has deviated from its original real value, it did not in relation to its existing fair value.  A new and higher core value is in place.  When a new and higher core value occurs after a deviation, the price will only pull back to its new fair value which is now extremely close to the current price.  In these circumstances, the asset may only consolidate without falling significantly.

4/ meanwhile, the overbought oscillator is rectifying itself by returning to its relative true value (water line)

B/ Below the zero line

A dynamically bearish financial instrument exhibits two fundamental characteristics:

- the price is falling continuously

- lastly, the true value is also falling at the same time or oven at the same rate.

The oscillator may give a counterfeit oversold warning because a new lower fair value

is recorded each time the price has fallen.  This is forcing the original real value to become obsolete.  Although, the deviation that is taking place is only justifiable if one is comparing the asset to the original core value, it is a false discrepancy because the original real value has also fallen.  In fact, there is no real deviation at all.  Similarly, in the case A/ (discussed above), the oscillator has deviated from its RTV, and it is now returning to it (without the price following the same pattern).  It is a warning one can disregard if one understand exactly what is taking place.

 

In contrast, if the initial true value did not decrease (or it is not likely to decrease, or there are no fundamental reasons why it should sooner or later decrease) while the price was falling substantially, the asset may become oversold at the same time like the indicator.

False oversold signal occurs when:

1/ the asset price is falling at the same time or even at the same rate like its original true value

2/ the indicator becomes oversold

3/ the oscillator is rising back to its RTV

4/ the price is not getting higher to its first true value like the indicator (or was consolidating), therefore, invalidating the warning.

Advanced MACD trading

When Gerald Appels oscillator is overbought, it will cross below its signal line provided that it is not distorted due to high impact economic news such as Non Farm employment change or GDP or ISM.  In normal conditions, it will revisit its RTV (water line).  In this case (false overbought signal), when the oscillator is too high, the price quite often will be at a resistance level.  This is true 80% of time on all time frames (this is our observation).  Note that the difference between the asset price and its current core value is almost negligible (at least insignificant in the current market environment) after a justifiable deviation .  It is crucial to understand that, when a new fair value occurs, it corresponds to a new equilibrium line.  As MACD has its own equilibrium line, so has the price.  Each fair value represents an equilibrium line. Smart market participants always pay attention to these equilibrium price levels.

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Indeed, when the oscillator reaches the overbought region, the price is also at resistance level, but the resistance level is on or near an equilibrium line.  MACD will return to its equilibrium line, but the price is already in an equilibrium zone; therefore will consolidate (not fall considerably) while the technical oscillator is heading south.

A resistance level becomes a zero level (ZL) when it is truly near to the current core value.  If the fundamentals are sound in a regular market, the price may consolidate for a while only to resume the previous bullish progression.

For the sake of keeping this writing short, we will not expand on the false oversold signal.

However, it is vital to keep in mind that the price will reach a support level when the oscillator becomes oversold.  If that support level is weak because the core value has been decreasing at the same time like the price (and the market fundamentals have not changed), the price may continue the move to the down side.  When a support level becomes a resistance level or a resistance level becomes a support level, they are zero level or ZL .  During a misleading signal, more than seventy five per cent of time, the price is at a zero level.  Note that this argument has combined both the technical and fundamental analysis to decipher the language of MACD.

Conclusion

All technical indicators give out warnings including MACD .  However, to filter out false warnings, and steer clear of costly mistakes, one must meticulously be familiar with the theory.  Apart from that, one should also understand the difference between theory and the reality of this messy market without violating basic market principles or the three channels.  This writing does not discount previous articles about MACD, but promotes a practical way for trading and interpreting the Gerald Appel oscillator.  To know more about fundamental analysis, we recommend that traders familiarized themselves with Google finance, Yahoo finance, Bloomberg, Financial times and Forex factory. To achieve consistent winning trades, it is crucial to adopt both technical and fundamental analysis. We hope you have enjoyed this article and have gained something from it to make profitable trading decisions.  Until the next time, enjoy yourself and be extremely happy.  Trade well.