Stock Technical Analysis – Technical Indicators (Part 2)?
In the late seventies, Gerald Appel developed the Moving Average Convergence and Divergence (MACD) indicator. Traders consider MACD as the grand old daddy of indicators. Though invented in the seventies, MACD is still considered one of the most reliable momentum traders indicators.
[br] [br] As the name suggests, MACD is all about the convergence and divergence of the two moving averages. Convergence occurs when the two moving averages move towards each other, and divergence occurs when the moving averages move away. [br] A standard MACD is calculated using a 12 day EMA and a 26 day EMA. Please note, both the EMA?s are based on the closing prices. We subtract the 26 EMA from the 12 day EMA, to estimate the convergence and divergence (CD) value. A simple line graph of this is often referred to as the ?MACD Line?. Let us go through the math first and then figure out the applications of MACD. [br] Date Close 12 Day EMA 26 Day EMA MACD Line
1-Jan-14 6302
2-Jan-14 6221
3-Jan-14 6211
6-Jan-14 6191
7-Jan-14 6162
8-Jan-14 6175
9-Jan-14 6168
10-Jan-14 6171
13-Jan-14 6273
14-Jan-14 6242
15-Jan-14 6321
16-Jan-14 6319
17-Jan-14 6262 6230
20-Jan-14 6304 6226
21-Jan-14 6314 6233
22-Jan-14 6339 6242
23-Jan-14 6346 6254
24-Jan-14 6267 6269
27-Jan-14 6136 6277
28-Jan-14 6126 6274
29-Jan-14 6120 6271
30-Jan-14 6074 6258
31-Jan-14 6090 6244
3-Feb-14 6002 6225
4-Feb-14 6001 6198
5-Feb-14 6022 6176
6-Feb-14 6036 6153 6198 -45
7-Feb-14 6063 6130 6188 -58
10-Feb-14 6053 6107 6182 -75
11-Feb-14 6063 6083 6176 -94
12-Feb-14 6084 6066 6171 -106
13-Feb-14 6001 6061 6168 -107 [br] Let us go through the table starting from left: [br] We have the dates, starting from 1st Jan 2014
Next to the dates, we have the closing price of Nifty
We leave the first 12 data points (closing price of Nifty) to calculate the 12 day EMA
We then leave the first 26 data points to calculate the 26 day EMA
Once we have both 12 and 26 day EMA running parallel to each other (6th Feb 2014) we calculate the MACD value
MACD value = [12 day EMA ? 26 day EMA]. For example, on 6th Feb 2014, 12 day EMA was 6153, and 26 day EMA was 6198. Hence the MACD would be 6153-6198 = ? 45Let us go through the table starting from left:When we calculate the MACD value over 12 and 26 day EMAs and plot it as a line graph, we get the MACD line, which oscillates above and below the central line.Date Close 12 Day EMA 26 Day EMA MACD Line
1-Jan-14 6302
2-Jan-14 6221
3-Jan-14 6211
6-Jan-14 6191
7-Jan-14 6162
8-Jan-14 6175
9-Jan-14 6168
10-Jan-14 6171
13-Jan-14 6273
14-Jan-14 6242
15-Jan-14 6321
16-Jan-14 6319
17-Jan-14 6262 6230
20-Jan-14 6304 6226
21-Jan-14 6314 6233
22-Jan-14 6339 6242
23-Jan-14 6346 6254
24-Jan-14 6267 6269
27-Jan-14 6136 6277
28-Jan-14 6126 6274
29-Jan-14 6120 6271
30-Jan-14 6074 6258
31-Jan-14 6090 6244
3-Feb-14 6002 6225
4-Feb-14 6001 6198
5-Feb-14 6022 6176
6-Feb-14 6036 6153 6198 -45
7-Feb-14 6063 6130 6188 -58
10-Feb-14 6053 6107 6182 -75
11-Feb-14 6063 6083 6176 -94
12-Feb-14 6084 6066 6171 -106
13-Feb-14 6001 6061 6168 -107
14-Feb-14 6048 6051 6161 -111
17-Feb-14 6073 6045 6157 -112
18-Feb-14 6127 6045 6153 -108
19-Feb-14 6153 6048 6147 -100
20-Feb-14 6091 6060 6144 -84
21-Feb-14 6155 6068 6135 -67
24-Feb-14 6186 6079 6129 -50
25-Feb-14 6200 6092 6126 -34
26-Feb-14 6239 6103 6122 -19
28-Feb-14 6277 6118 6119 -1
3-Mar-14 6221 6136 6117 20
4-Mar-14 6298 6148 6112 36
5-Mar-14 6329 6172 6113 59
6-Mar-14 6401 6196 6121 75
7-Mar-14 6527 6223 6131 92
10-Mar-14 6537 6256 6147 110
11-Mar-14 6512 6288 6165 124
12-Mar-14 6517 6324 6181 143
13-Mar-14 6493 6354 6201 153
14-Mar-14 6504 6380 6220 160Given the MACD value, let?s try and find the answer for a few obvious questions:What does a negative MACD value indicate?
What does a positive MACD value indicate?
What does the magnitude of the MACD value actually mean? As in, what information does a -90 MACD convey versus a ? 30 MACD?The sign associated with the MACD just indicates the direction of the stock?s move. For example, if the 12 Day EMA is 6380, and 26 Day EMA is 6220, the MACD value is +160. Under what circumstance do you think the 12 day EMA will be greater than the 26 day EMA? Well, we had looked into this in the moving average chapter. The shorter-term average will generally be higher than the long term only when the stock price trends upward. Remember, the shorter-term average will always be more reactive to the current market price than the long term average. A positive sign tells us that there is positive momentum in the stock, and the stock is drifting upwards. The higher the momentum, the higher is the magnitude. For example, +160 indicate a positive trend which is stronger than +120.However, while dealing with the magnitude, always remember the price of the stock influences the magnitude. For example, the higher the underlying price such as Bank Nifty, naturally, the higher will be the magnitude of the MACD.When the MACD is negative, it means the 12 day EMA is lower than the 26 day EMA. Therefore the momentum is negative. Higher the magnitude of the MACD, the more strength in the downward trend.The difference between the two moving averages is called the MACD spread. The spread decreases when the momentum mellows down and increases when the momentum increases. To visualize convergence and the divergence traders usually plot the MACD value chart, often referred to as the MACD line.The following is the MACD line chart of Nifty for data points starting from 1st Jan 2014 to 18th Aug 2014.As you can see, the MACD line oscillates over a central zero line. This is also called the ?Centerline?. The basic interpretation of the MACD indicator is:When the MACD Line crosses the centerline from the negative territory to positive territory, it means there is a divergence between the two averages. This is a sign of increasing bullish momentum; therefore, one should look at buying opportunities. From the chart above, we can see this panning out around 27th Feb
When the MACD line crosses the centerline from positive territory to the negative territory, it means there is a convergence between the two averages. This is a sign of increasing bearish momentum; therefore, one should look at selling opportunities. As you can see, there were two instances during which the MACD almost turned negative (8th May, and 24th July) but the MACD just stopped at the zero lines and reversed directions.Traders generally argue that while waiting for the MACD line to crossover the centerline, a bulk of the movie would already be done and perhaps it would be late to enter a trade. To overcome this, there is an improvisation over this basic MACD line. The improvisation comes in the form of an additional MACD component which is the 9-day signal line. A 9-day signal line is an exponential moving average (EMA) of the MACD line. If you think about this, we now have two lines:A MACD line
A 9 day EMA of the MACD line also called the signal line.A trader can follow a simple 2 line crossover strategy with these two lines as discussed in the moving averages chapter and no longer wait for the centerline cross over.The sentiment is bullish when the MACD line crosses the 9 day EMA wherein MACD line is greater than the 9 days EMA. When this happens, the trader should look at buying opportunities.
The sentiment is bearish when the MACD line crosses below the 9 day EMA wherein the MACD line is lesser than the 9 day EMA. When this happens, the trader should look at selling opportunities.The chart below plots the MACD indicator on Asian Paints Limited. You can see the MACD indicator below the price chart.The indicator uses standard parameters of MACD:12 day EMA of closing prices
26 day EMA of closing prices
MACD line (12D EMA ? 26D EMA) represented by the black line
9 day EMA of the MACD line represented by the red lineThe chart?s vertical lines highlight the chart?s crossover points where a signal to buy or sell originated.For example, the first vertical line starting from left points to a crossover where the MACD line lies below the signal line (9 day EMA) lies and suggests a short trade.The 2nd vertical line from left points to a crossover where the MACD line lies above the signal line should look at buying opportunity. So on and so forth.Please note, at the core of the MACD system, are moving averages. Hence the MACD indicator has similar properties like that of a moving average system. They work quite well when there is a strong trend and are not too useful when moving sideways. You can notice this between the 1st two-line starting from left.Needless to say, the MACD parameters are not set in stone. One is free to change the 12 days, and 26 day EMA to whatever time frame one prefers. I personally like to use the MACD in its original form, as introduced by Gerald Appel.15.2 ? The Bollinger BandsIntroduced by John Bollinger in the 1980s, Bollinger Bands (BB) is perhaps one of the most useful technical analysis indicators. BB is used to determine overbought and oversold levels, where a trader will try to sell when the price reaches the top of the band and will execute a buy when the price reaches the bottom of the band.The BB has 3 components:The middle line which is The 20 day simple moving average of the closing prices
An upper band ? this is the +2 standard deviation of the middle line
A lower band ? this is the -2 standard deviation of the middle lineThe standard deviation (SD) is a statistical concept; which measures a particular variable?s variance from its average. In finance, the standard deviation of the stock price represents the volatility of a stock. For example, if the standard deviation is 12%, it is as good as saying that the stock?s volatility is 12%.In BB, the standard deviation is applied on the 20 days SMA. The upper band indicates the +2 SD. Using a +2 SD, we multiply the SD by 2 and add it to the average.For example if the 20 day SMA is 7800, and the SD is 75 (or 0.96%), then the +2 SD would be 7800 + (75*2) = 7950. Likewise, a -2 SD indicates we multiply the SD by 2 and subtract it from the average. 7800 ? (2*75) = 7650.We now have the components of the BB:20 day SMA = 7800
Upper band = 7950
Lower band = 7650Statistically speaking, the current market price should hover around the average price of 7800. However, if the current market price is around 7950, it is considered expensive concerning the average. Hence one should look at shorting opportunities with an expectation that the price will scale back to its average price.Therefore the trade would be to sell at 7950, with a target of 7800.Likewise, if the current market price is around 7650, it is considered cheap concerning the average prices. Hence, one should consider buying opportunities to expect that the prices will scale back to its average price.Therefore the trade would be to buy at 7650, with a target of 7800.The upper and lower bands act as a trigger to initiate a trade.The following is the chart of BPCL Limited,