Trading The MACD Histogram

 As good as the moving average convergence/divergence is, adding the histogram might make it even better.

One of the first trading methodologies I ever cobbled together was based on the moving average convergence/divergence histogram, also known as the MACD histogram (or even the MACDH for short). I won’t pretend my selection of the histogram came as the result of a scientific survey— though there was enough trial and error to make me feel as if some sort of canvassing of available indicators had certainly taken place. If anything, I was moved to spend more time getting to know the MACDH after reading this entry from Alexander Elder’s excellent trading primer, Trading For A Living:

MACD-Histogram offers a deeper insight into the balance of power between bulls and bears than the original MACD. It shows not only whether bulls or bears are in control, but also whether they are growing stronger or weaker. It is one of the best tools available to a market technician.

And later, under the heading “The strongest signal in technical analysis”:

Divergences between MACD-Histogram and prices occur only a few times a year in any given market, but they give some of the most powerful messages in technical analysis. These divergences identify major turning points and give “extra-strength” buy or sell signals. They do not occur at every important top and bottom, but when you see one, you know that a major reversal is probably at hand.

If that’s not an endorsement, then I don’t know what is. I’m not sure if Elder feels as strongly about the “MACD-Histogram” today in 2006 as he did back in 1993 when Trading For A Living was completed, but the indicator itself continues to have adherents. For example, Raghee Horner, forex trader and author, has used the MACDH as a general indicator to determine whether a market is bullish and ripe for buying or bearish and ripe for selling.

I’ve written about the MACD histogram before for Working-Money.com, particularly about what I referred to as “MACDH extremes,” which can often be helpful in determining intermediate-term direction after major market moves and when dealing with consolidations. Here, however, I want to talk about a few of the basic ways that traders can and have used the MACD histogram in order to trigger trade entries as well as determining directionality.

MEET MR. MACD

What exactly is the MACD histogram? What is its relationship to the moving average convergence/ divergence indicator known as the MACD?

The MACDwas developed by trader Gerald Appel, who also publishes the Systems And Forecastsnewsletter. Although the MACD appears with two lines that converge and diverge relative to each other, the indicator is actually created using three lines. Writing in his book The Visual Investor, John Murphy explains how the MACD is constructed:

The first line (called the MACD line) is the difference between two exponentially smoothed moving averages of the price (usually 12 and 26 periods). The computer subtracts the longer average (26) from the shorter (12) to obtain the MACD line. A moving average (usually nine periods) is then used to smooth the MACD line to form a second (signal) line. The result is that two lines are shown on the chart, the faster MACD line: and the slower signal line.

Buy and sell signals using the MACDare similar to those using other pairs of moving averages. When the fast MACDline crosses above the slow signal line, a buy signal has been issued. Conversely, when the fast MACD line crosses below the slow signal line, a sell signal has been issued. Approaching the MACD this way means that the trader will tend to be on the right side of the trend when following the signals. As I’ll show later, there can be other tools that traders will use — from moving averages to trendlines to the MACD histogram — to determine whether the trend they may have received a signal to follow is one of significant duration, as in a bullish or bearish context.

(See Figure 1.)

FIGURE 1: SEARS HOLDINGS CORP., DAILY. The basic MACD is shown here, along with one of the more common buy signals that can be derived from it. The highlighted section in the indicator window shows where the faster MACD line (in blue) crossed over the slower signal line (in red). The highlighted session shows the candlestick above which the long trade would be initiated.

For now, suffice to say that the MACD can be used on a variety of time frames using this simple crossover methodology. In addition, while John Murphy notes that some traders have elected to use different values for buy signals and sell signals, he underscores that for most traders, the 12, 26, 9 values will work for both bullish and bearish signals.

There are two other ways that the MACD can be used. One is as an oscillator. Insofar as the two lines— the MACD line and the signal line — both operate above and below a zero line, some traders have used the MACD to indicate oversold market conditions that can be bought (both lines below the zero line) as well as overbought market conditions that can be sold (both lines above the zero line).

Murphy points out that some traders combine the crossover and oscillator aspects of the MACD by looking for bullish crosses (remember, the MACD line crossing above the signal line) below the zero line indicating a buy and bearish crosses (the MACD line crossing below signal line) above the zero line as indicating a sell.

Traders have also used the MACD to spot divergences. In much the same way that traders use oscillators like the RSI (relative strength index) and stochastics, traders look for instances when the MACDmakes a lower high while a market is making a higher high (a negative divergence) or when the MACDmakes a higher low while a market is making a lower low (a positive divergence).

So where does the histogram fit into all of this? According to Murphy, in a way that makes it even better. He writes:

As good as the MACD indicator is in the form just described, there’s a way to make it even better. That technique is called the MACD histogram. The MACD histogram will provide even earlier warnings of potential trend changes and greatly enhances the value of the indicator. Since the histogram shows the MACD crossover signals (in a slightly different way), nothing is lost in its use. What is gained is a way to generate action signals much sooner.