Moving Averages and MACD

Moving Averages (MA)

The moving average is a trend following indicator that helps smooth price action and filter out market noise. It follows, rather than predicts, market action. MAs are primarily used to:

• Identify the direction of the trend.
• Define potential support and resistance levels.

It can be viewed as a curving trend line.

Calculating Simple Moving Averages (SMA)

To calculate an SMA, you sum the closing prices over a specific number of time periods (the lookback period) and divide by that number.

Example: Three-Day Moving Average

The closing prices of the last three days are added and divided by three:

• Day 1 MA: (20 + 19 + 18) / 3 = 19
• Day 2 MA: (19 + 18 + 17) / 3 = 18
• Day 3 MA: (18 + 17 + X) / 3 = Next MA value

MA Period Selection

The critical element is the number of time periods used. Shorter MAs are closer to the price and more sensitive to movements than longer MAs.

Traders must find an MA that is consistently profitable and fits their targeted market cycle:

• Short-term traders: Use 5 to 25 period averages.
• Medium-term traders: Use 26 to 49 period averages.
• Long-term traders: Use 50 to 200 period averages.

Price Basis for Calculation

Most MA calculations use the closing price, as it is considered the most important price by market participants. However, MAs can also be constructed using:

• The high, the low, or the open of the period.
• The Median Price: (High + Low) / 2
• The Typical Price: (High + Low + Close) / 3
• The Weighted Close Price.

Criticisms of the Simple Moving Average (SMA)

The SMA has two main criticisms:

1. It only considers the prices within the lookback period (e.g., the last 10 days).
2. It gives equal weight to each price within the lookback period.

Types of Moving Averages Based on Weighting

The only significant difference between various MA types is the weight assigned to the data points:

• Simple Moving Average (SMA): Applies equal weight to all prices.
• Exponential and Weighted Averages: Apply more weight to recent prices.
• Triangular Averages: Apply more weight to prices in the middle of the time period.
• Variable Moving Averages: Change the weighting based on price volatility.

Interpreting Moving Average Signals

1. Price Crossover Method

This is the simplest method, comparing the MA to the security's price.

• Bullish Signal: Prices rise above the moving average.
• Bearish Signal: Prices fall below the moving average.

2. Double Crossover Method

This technique uses two MAs: one relatively short and one relatively long. The length of the MAs defines the system's time frame (e.g., 5-day/20-day is short-term; 50-day/200-day is long-term).

• Bullish Crossover: The shorter MA crosses above the longer MA.
  • The 50-day MA crossing above the 200-day MA is known as a Golden Cross.
• Bearish Crossover: The shorter MA crosses below the longer MA.
  • The 50-day MA crossing below the 200-day MA is known as a Death Cross.

3. Triple Crossover Technique

This method uses three MAs to help avoid the false signals (whipsaws) encountered in the double crossover technique. A popular combination uses 4, 9, and 18 periods, or 5, 10, and 20 periods.

Using the 5, 10, and 20 combination:

• Buy Signal (Bullish Alignment): The 5-day MA must be above the 10-day MA, and the 10-day MA must be above the 20-day MA. The entry is activated only when the 5-day MA crosses above the 10-day MA, provided the 10-day MA is already above the 20-day MA.
• Sell Signal (Bearish Alignment): The 5-day MA must be below the 10-day MA, and the 10-day MA must be below the 20-day MA. The entry is activated only when the 5-day MA crosses below the 10-day MA, provided the 10-day MA is already below the 20-day MA.

4. Moving Average Ribbon

The ribbon combines eight or more MAs, capturing various time cycles. A popular combination uses four short-term (4, 7, 11, and 16 period EMAs) and four long-term (25, 30, 35, and 40 period EMAs).

Note on MA effectiveness: MAs are excellent trend indicators, but refrain from using them when the market is range-bound, as they produce many false signals (whipsaws).

Moving Average Convergence Divergence (MACD)

Developed by Gerald Appel, the MACD is a hybrid indicator used for trend following and momentum analysis. It is calculated based on Exponential Moving Averages (EMAs).

MACD Components

1. The MACD Line: The difference between the 12-period EMA and the 26-period EMA.
   • When the 12-period EMA crosses above the 26-period EMA, the MACD line crosses the zero line from negative to positive territory.
   • When the 12-period EMA crosses below the 26-period EMA, the MACD line crosses the zero line into negative territory.
2. The Signal Line: A 9-period EMA of the MACD line.

Interpreting MACD Signals

1. Centerline Crossover (Trend Direction)

This compares the MACD line against the 0 line.

• Bullish Centerline Crossover: The MACD line moves above the zero line (turns positive).
• Bearish Centerline Crossover: The MACD line moves below the zero line (turns negative).

2. Signal Line Crossover (Potential Price Corrections)

This compares the MACD line against the Signal line.

• Bullish Crossover: The MACD line turns up and crosses above the Signal line.
• Bearish Crossover: The MACD line turns down and crosses below the Signal line.

The MACD Histogram

Developed by Thomas Asprey in 1986, the MACD histogram measures the distance between the MACD line and its Signal line.

Calculation and Display

• Calculation: MACD Line - Signal Line
• The histogram is presented as vertical bars instead of a line.
• The MACD histogram is at 0 when the MACD line is crossing its Signal line.
• When MACD crosses below its signal line, the histogram moves below zero.
• When MACD crosses above its signal line, the histogram moves above zero.

Interpretation and Purpose

Because the MACD uses lagging moving averages, the histogram is designed to alert traders to an imminent Signal Line crossover, anticipating trend changes well in advance of the normal MACD signal (though it is less reliable).

• Bearish Divergence: A downward slant in the histogram implies negative divergence between MACD and its Signal line.
• Bullish Divergence: An upward slant in the histogram implies positive divergence between MACD and its Signal line.