MACD stands for Moving Average Convergence Divergence. It is a technical
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
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 market’s 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
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
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
- 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 Appel’s 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.
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.
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.
Click on the picture to learn
TS MACD PRO detects high probability trades from the
four hours and daily charts. Without viable set ups,
trading signals are useless. Please request your free
Swing 240 if you have already purchased the TS MACD PRO.