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| Articles and Tutorials |
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| "Big MAC Divergence" |
| by Ryan Litchfield |
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Indicators are a powerful tools and they generally have a very specific function. They
measure specific aspects of behavior and that behavior is compared to the chart movement.
Some indicators are very narrow in focus i.e. only relevant in trends or only in
compression patterns while other indicators work well in nearly any market patterns.
Some of the more common and respected indicators measure over bought / oversold
conditions or trend strength or divergence. I will focus this article on the
divergence indicators and how to recognize divergence.
There are several indicators that can be used for divergence. They vary in their
accuracy as some measure divergence as their primary function and others as a
secondary function. The most recognized divergence indicator is Gerald Appel's
Moving Average Convergence Divergence (MACD). This indicator compares moving
averages to each other and gives Bullish and Bearish signals but it's real unique
quality is to predict major changes in direction by revealing discrepancies in it's
pattern with the chart's pattern before the change. MACD is well respected and the
general adage is that MACD will have a significant discrepancy with the stock chart
2-3 times per year.
MACD may be displayed both as a two line indicator and a Histogram.
While the data is the same, the Histogram is not the form that gives the major
divergence signals. In fact the use of the histogram is somewhat controversial.
Construed by Thomas Aspray, it attempts to anticipate the cross over of the faster
(green) and slower (red) lines which gives a bullish and or bearish signal. This is
a secondary talent for MACD so for the discussion of divergence, we will focus on the
original two line version. In looking for divergence, the two lines are looked upon
as one. The two line chart is formed by entering 3 time frames to the moving average
formulas. The classic data points are 12, 27 and 9. For shorter term trading I use
a shorter time frame setting of 8, 18 and 6. There is also a Zero / Center line for
reference.
MACD can predict changes but the time frame can vary dramatically. The predicted
change can show up one week or many weeks later. The prediction is usually right
but not necessarily right away. The actual change usually happens at a support or
resistance line. Early divergence should have you looking closely at your chart for
your key pivot points.
Divergence is the measurement of discrepancy. When two things are measured and
compared to each other, they are either moving the same way or diverging. MACD
stands for convergence and divergence. That means that the pattern of the
indicator may be moving toward the stock (convergence) or away from it (divergence).
This can be confusing and assumes that the stock chart is on top of the indicator chart.
While you can learn to understand and read MACD this way there is something that
can make it easier to learn and interpret.
Simplify terms (lose the convergence)
The normal way to display MACD is to place it in a separate window below the chart
window. The confusion I mentioned comes from directional terms assigned to MACD.
Converging (coming toward) and diverging (moving away) are only relevant because
of the position of the two windows. For example, if you placed the indicator window
on top of the chart window, convergence and divergence would switch roles.
I prefer to relate divergence to the core issue, bullish or bearish divergence.
The distinction of convergence and divergence are unnecessary. Divergence is
discrepancy. If you are moving the same direction as the stock you are in sync
with it, agreeing with it. If you are not, you are diverging. It does not matter
if you are moving toward or away, you are diverging. That divergence will
either have a bullish or bearish warning.
I teach my students to use the terms "Bullish and Bearish Divergence". Convergence
is done away with altogether. If MACD is moving down while the stock is moving up,
it is Bearish Divergence. A rising indicator against a falling stock is Bullish Divergence.
Divergence is not too tough to see but it takes time to get comfortable with it.
Keep in mind that the settings control how far back you can look for relevance. The
12, 27, 9 settings will let you compare more time than 8, 18, 6. In other words
you can not look at a peak in February and compare it's height to a peak 6 months
earlier. There is no 0 to 100 scale. The Zero / Center line allows MACD to reset.
You can only use about 2 -3 months of time when using the shorter settings and 3-4
months with the longer settings.
But you can compare the neighboring few months to any spot you pick as a starting
point. This is very helpful in learning from history. You can practice identifying
divergence by using the historical data. At any point you can look 2-3 months
either forward or back.
Divergence in MACD is a real gem. At 2 - 3 times per year it is a great consultant
and forecaster of trend change. As with any indicator, it is best to have a few
opinions and look for multiple confirmations. Support and resistance lines will
generally correlate with the reversal signals predicted by MACD. While there is still
much more to learn about MACD , Divergence is the first and most valuable characteristic.
Interested in learning more? I invite you to sign up to attend one of my free trading webshops.
-- Ryan
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