In technical analysis, Moving Average Convergence Divergence (MACD) indicators are used to gauge market trends by averaging daily closing prices of stocks, commodities or indices. MACD values are calculated by plotting these daily points in a graph to allow traders to take a look at the smoothened data, rather than day to day price fluctuations that are inherent in the financial markets. The common application of using the moving average for the past 10 days, 50 days or 200 days is to compare the latest closing prices of stocks/ indices with the MACD graph. The thumb rule for further buying in any stock for is to buy when the latest price points lie above the 50 days or 200 days MACD as this is viewed as a sign of long-term strength in that stock/index. Conversely, no short positions should be built, in case the medium term or long term (200 days) moving average is below the closing line of latest price point of index. There are two types of moving average followed popularly in the financial markets.
The more commonly used moving average by the traders is the simple moving average method, according to which the trailing price points of several days (10, 50, 100 or for a longer term upto 200 days) are averaged and plotted on graph. Such a graph changes every day, by eliminating the oldest data point, and adding the latest data point. This is compared with the latest price point to check if the stock/ index is lying above or below the moving average chart. The other method of moving average convergence-divergence (MACD) is the exponential MACD, which gives more weight to the last few price points, and gives a lower weight to the oldest data, to bring down their importance. However, there are only few traders who follow an exponential moving average method to check the momentum of the stock/ index. Also, if one gets to super-impose the short term MACD on the chart of longer term MACD and the short-term chart is trending lower than the long term MACD, there are chances that stock could reverse its movement to move in a lower direction (See Chart 1).
The theory of MACD was initially developed by Gerald Appel over forty years back, for 12 days and 26 days, that was later expanded gradually up to 200 days. Gerald Appel is the president of Signalert Corporation, an investment advisory firm that manages approximately $280 million in capital. Signalert also publishes the technical newsletter Systems and Forecasts, highly rated by The Hubert Financial Digest and by Timer Digest for its performance in market timing.
Gerald has written twelve books relating to investment strategies, including Winning Market Systems, Double Your Money Every Three Years, Stock Market Trading Systems, The Big Move, New Directions in Technical Analysis (co-author, Dr. Martin E. Zweig), and Time-Trend III.
Many successful traders have mentioned using moving averages as one of the indicators they rely on. William O'neil and David Ryan, very successful stock traders (alelgedly have compounded at 40+% according to the book Market Wizards) who are followers of the CAN SLIM system and Investors' Business Daily, will not buy a stock unless the chart is above the 50 day and 200 day simple moving averages. They may consider adding to their existing positions when the stock bounces off the 50 day or 200 day moving average, with a strict stop-loss policy. Technical trader of commodities Ed Seykota (who turned 10,000 to 10 million according to Market Wizards), along with ultra successful Richard Dennis (who built a 200 million dollar fortune), used a modified version of moving averages, called the Donchian channels. Stan Weinstein, another successful trader from the 1980s, also used moving averages. Some critics claim that moving averages work only because many people follow it. In other words, it is a self-fulfilling prophecy.
Value investors (Benjamin Graham, Warren Buffett, Marty Whitman), who buy stocks as a share of the businss, think moving averages would be a bunch of hogwash. If you are buying a fractional share of a business, why would you care if the stock price is bouncing off a 50 day moving average? What matters to the value investor is the fundamentals (cash flow, balance sheet) of the business. The followers of moving averages may retort to the value investors that if they had followed their sell signals from moving averages, they would have cut their losses in AIG when it was in the high 40s, not in the single digit range.
Moving day averages can give the best signals of buying and selling during times when a security is trending. However, in such cases where the stock markets continue to remain and move in a range bound manner, it is difficult to take any decisions on the basis of moving average day charts. This is because the MACD charts give confusing patterns due to lack of any specific direction they may be able to take. Hence, the critics of moving average day theory advise against using such a theory for taking positions in the market during times when the financial markets move in a range bound manner. It is now popularly understood that MACD theory should only be taken as a trend indicator, but not on a real time basis in the markets. The moving average day theory is used in different financial markets, which include stock markets, foreign exchange movements and even in commodity trading.
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