MACD and power of Histogram

Convergence or Divergence, all technical indicators must be in coherence with one another. Moving Averages form the basis of yet another powerful tool - Moving Average Convergence and Divergence or MACD. This is so powerful and essential that nearly all traders rely on MACD as one of their primary indicators.

MACD uses EMA (Exponential Moving Average) to pictorially represent the direction of price movement. Generally denoted by MACD(a,b,c); the parentheses have 3 values of time periods for calculation of MACD. It uses a fast EMA (a) and a slow EMA (b) to direct traders to place their bets. The most common is MACD (12,26,9).

MACD is a kind of price oscillator, as its value changes with the change in price. There are 3 kinds of price oscillator:

1. APO (Absolute Price Oscillator): the indicator dealing with absolute prices
2. PPO (Percentage Price Oscillator): the indicator dealing with percentage change of prices, normalising the change in MA by dividing with MA of the higher time period. It shows the relationship between two Moving Averages in Percentage terms
3. DPO (Detrended Price Oscillator): the indicator which emphasises short term trends ignoring long term trends

MACD is part of the APO family as it deals with absolute prices. PPO is preferred when different securities are compared or when the same security is compared at significantly different time frames having large differences in prices, and therefore normalization is helpful.

Familiarizing the indicator on the chart:

There are 3 components of MACD:

1. Series proper or MACD: its difference between fast EMA (a) and slow EMA (b)
2. Average series or MACD Signal: EMA of series proper with time period equal to “c”.
3. Divergence or MACD Histogram: usually depicted as Histogram, it’s the difference between MACD and MACD Signal line

As all the steps involve using of EMA or already calculated indicator, MACD is also referred to as the indicator of indicators.

Stage 1: EMA (a) & EMA (b)

Stage 2: MACD = EMA of [EMA (a) - EMA (b)]

Stage 3: Signal line = EMA (c) of MACD

Stage 4: Histogram = MACD - Signal

Identifying Crossovers

Zero Crossover (MACD crossover with respect to centreline or horizontal X-axis):

Since MACD is the difference between Fast EMA & Slow EMA, it can be broadly said that when MACD is above zero it is an uptrend and when MACD is below zero it is a downtrend. In the case of an uptrend, go for longing and in a downtrend, go for shorting. Moving from below to above the centreline can be considered as bullish and from above to below can be considered as bearish.

Signal Line Crossover (MACD crossover with respect to MACD signal line)

It is often considered that when a stock (or crypto) accelerates in the direction of the crossover, there are two types of possibilities:

1. Bullish Crossover: when MACD crosses the signal line from bottom to top it is a sign of bullishness or time to buy the security. Histogram value increases from 0 to +ve peak.
2. Bearish Crossover: when MACD crosses the signal line from top to bottom it is a sign of bearishness or time to sell the security. Histogram value increases from 0 to -ve peak.
   

Convergence and Divergence

1. Convergence occurs when momentum decreases and the value of Histogram decreases from peak (+ve or -ve) to 0 axis. (or MACD moves closer to the signal line). This contraction can be treated as early signs of crossover.
2. Divergence occurs when momentum increases and the value of Histogram increases from 0 axis to peak (+ve or -ve). (or MACD moves away from the signal line). This expansion can be treated as early signs of reaching the peak or closing the position.

It is called MACD (Moving Average Convergence & Divergence) as we have to first identify convergence in Histogram (loss of momentum) which will be automatically followed by divergence (on the opposite side) accompanied by a gain of momentum.

1. Close Long, Enter Short: If the security is losing momentum on the upside it would diverge to the downside, a reversal from an uptrend to downtrend would happen soon
2. Close Short, Enter Long: If the security is losing momentum on the downside it would diverge to the upside, a reversal from downtrend to uptrend would happen soon

There are two types of divergences:

1. Peak-trough divergence: Two peaks or two troughs of Histogram are involved
2. Slant Divergence: In this case well defined peaks or troughs are not formed but the estimate is done using the slant of the histogram

Bullish Divergence or Positive Divergence:

When MACD or price action makes lower low and histogram makes a higher low.

Bearish Divergence or Negative Divergence: 

When MACD or the price action makes a higher high but the histogram makes a lower high.

Mathematical Formula

Most commonly used APO (Absolute Price Oscillator) MACD:

1. MACD = EMA (12) - EMA (26)
2. MACD SIgnal = EMA (9) of MACD
3. MACD Histogram (Divergence) = MACD - MACD Signal

PPO (Percentage Price Oscillator) MACD:

1. PPO MACD = [EMA (12) - EMA (26)]/EMA (26) x 100
2. PPO MACD Signal = EMA (9) of PPO MACD
3. PPO MACD Histogram (Divergence) = PPO MACD - PPO MACD Signal

where,

MACD = Moving Average Convergence and Divergence

EMA (n) = Exponential Moving Average (Time Period ‘n’)

Word of Caution

MACD being a lagging indicator is not that useful for securities trading with erratic price action.

The PPO is prone to providing false crossover signals, both in terms of signal line crossovers and centerline crossovers. Assume the price is rising, but then moves sideways. The two EMAs will converge during the sideways period, likely resulting in a signal line crossover and potentially a centerline crossover. Yet the price hasn't actually reversed or changed direction, it just paused.

The indicator is also used to spot divergences, which may foreshadow a price reversal. Yet divergence is not a timing signal. It can last a long time, and won't always result in a price reversal.

The indicator is composed of the distance between two EMAs (the PPO), and an EMA of the PPO (signal line). There is nothing inherently predictive in these calculations. They are showing what has occurred, and not necessarily what will happen in the future.

Trading Points & Conclusion

1. Generally MACD (12,26,9) is used

2. Look for MACD crossover with respect to 0 line or horizontal x axis

• Enter Long: when it crosses from -ve region to +ve region
• Enter Short: when it crosses from +ve region to -ve region

3. Histogram crossover with respect to 0 line or horizontal x axis

• Enter Long: when it crosses from -ve region to +ve region
• Enter Short: when it crosses from +ve region to -ve region

4. Convergence (of the histogram), followed by divergence

• Price Action makes a lower low, Histogram makes higher low: Bullish divergence ahead, go for a long position
• Price Action makes higher high, Histogram makes lower high: Bearish divergence ahead, go for a short position