Moving averages are normally plotted on top of the price chart.
Moving average oscillators are constructed by plotting the difference between two moving averages on a separate axis beneath the price chart. The longer moving average usually forms the ‘zero’ line of the oscillator, with the shorter moving average oscillating around it.
The difference between the two moving averages is then displayed either as a points difference or (maybe better) a percentage difference. The purpose of moving average oscillators to:
- Identify divergences
- Note significant deviations between the two lengths of average
- Highlight moving average crossing
Moving Average Convergence / Divergence (MACD)
MACD is an extension of the moving average oscillator system above, execpt that in this case both moving averages are exponential. Note that MACD is a trend following technique; works well when in trends, not really good intra-day.
Once the long moving average and short moving average oscillator has been drawn, the MACD signal line can be plotted by calculating the exponential moving average of the difference between the fast and slow moving averages.
This gives a second line on the oscillator, which lags behind the MACD line. The signal line is the black line on the chart below.
MACD Trading Signals
- A buy signal is generated when the MACD line crosses above the signal live (and vice versa for a sell signal).
- Divergences can also be found, although the buy or sell signal is only confirmed once the zero line is crossed by both the MACD and signal lines.
- Trend lines can also be drawn on the oscillator, so that a break of a trend line on the actual oscillator, for example, could warn of a trend reversal before the price breaks its equivalent trend line.
Use your computer to plot the difference between the two MACD lines and display the difference as a histogram. Look for the first shorter bar on the positive side for sell signals. Look for the first shorter bar below the zero line for buys. The best signals are accompanied by divergences. Least good signals occur around the zero line.
You can use it to establish the trend direction by applying it to one time period higher. For example, if you are a trader who uses daily charts for analysis, apply the MACD-Forest/Histogram to weekly data to establish the trend direction. Then always trade in the direction of the trend.
The MACD histogram is an extremely effective way for short term traders to trade. It gives up much directional activity in exchange for timing. Short-term traders pay little attention to the overall trend direction; they are most interested in catch all the turns as they happen.
More technical analysis: