INSUBCONTINENT EXCLUSIVE:
The previous issues introduced the momentum indicator rate of change (ROC) and trading rules based on it
ROC is calculated as the difference between two price points, and therefore, it will be volatile
To make the indicator line smoother, technical analysts use two moving averages as they are already smooth
Moving average convergence divergence (MACD) is the best example of this
As the name suggests, MACD tracks the convergence and divergence between two moving averages.
Computation: MACD is computed by deducting a
mediumterm moving average from a shortterm moving average
Though any two moving averages can be used to calculate MACD, commonly used ones are 12-day and 26-day moving averages
As visible from the HCL Tech chart, the MACD gets close to zero when these two moving averages converge (or come close) and MACD go away
from zero when these two moving averages diverge (or move away).
Interpretation: In technical analysis, a counter is treated as bullish when
its short-term moving average is above medium-term moving average and is treated as bearish in reverse situations
The beauty of the MACD chart is that the crossover between moving averages is seen very clearly
In other words, a positive MACD indicates that the short-term moving average is above the medium-term one and therefore, shows a bullish
Similarly, a negative MACD indicates a bearish trend.
Trading rule 1: We have already seen that the MACD crossing the zero line, which is
also known as the central line, is very important and therefore, can be used as a buy/ sell signal
MACD cutting the central line from the bottom is treated as a buy signal and the same is marked with an up-arrow in the MACD Chart
Similarly, MACD cutting the central line from the top is treated as a sell signal and the same is marked with downarrow in the MACD
chart.
The main weakness of this zeroline crossover rule is that it will take place with a lag
This is because MACD is a trend-following indicator
Though traders can increase the sensitivity of MACD by using shorter moving averages for computing MACD (e.g
5-day and 12-day moving averages), the lag effect will still be there
To avoid this, traders usually use more sophisticated trading rules such as signal crossover and divergence
These trading rules will be covered in forthcoming issues.
