Learn How to Apply MACD to Your Trading - Part II

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A Refinement: Using MACD to Find Overbought/oversold areas

You are not limited to checking whether MACD is above or below zero - the actual level can be important as well, particularly at historical extremes. For example, if you calculate that MACD has gotten unusually far below zero, down to areas seen only at previous major market bottoms, it would be reasonable to use that observation as the basis for predicting that the market was due to turn back up.

We will see how that has worked with the Dow Jones Industrial Average, but first we need to digress to cover one more fine point.

When analyzing multi-year charts, prices can cover a very wide range. For example, if you use the formulas presented so far on a long-term chart of the Dow Industrials, you might get a result like what appears in Figure 2:

Figure 2: Dow Jones Industrial Average weekly, and three market declines, 1970-2008, along with the 12-26 week MACD expressed in points.

The three events shown in Figure 2 are the 1973-1974 bear market, the stock market crash of October 1987, and the recent (October 2007-March 2008) market correction. The worst extent of the price declines (based on weekly closes) is labeled.

Clearly, in terms of price decline, the recent correction is far milder than the other two historical events.

However, the decline in MACD was far more dramatic in 2008 than in 1987 or 1974. The reason is that the moving average formulas use price data, so a 100-point decline in the Dow Industrials can produce roughly the same point change in an exponential moving average regardless of whether the starting price is 1000 or 10,000.

What matters is not the general level of stock prices, but only the number of points that separate the stock price and its moving average. However, as equity investors, we are usually more interested in percentage changes than in point changes. (Futures traders may not agree.)

Fortunately, a simple additional calculation can create a MACD that reflects percentage changes so that the market action that occurred in disparate price ranges can be compared.

In order to normalize MACD, simply divide the original reading by the slower moving average.

In order to avoid confusion between the two different formulas, we will refer to the MACD in % calculated by equation 2 as "MACD%". If we utilize the formula for MACD% on the price history in Figure 2, we get the more consistent result that appears in Figure 3, where the magnitude of the moves in MACD% parallels the percentage changes in price.

Signals that have been correct 85% of the time

Now that we are in a position to compare MACD% readings from the 1970s (when the Dow Industrials peaked around 1000) and the current decade (where the Dow peaked at 14,000) we can see that the 12-26 week MACD% reached a major long-term oversold level when it got down to -3% or below.

That has only occurred seven times in the past 38 years. When MACD subsequently climbed back above -3%, it was a good time to enter the market on all but one of these occasions (November 2001).

The market correction that has carried into 2008 has not brought the 12-26 week MACD% of the Dow Industrials down as far as -3%. If it does, we would consider the subsequent recovery to be a good time to take new positions.

Figure 3: Dow Jones Industrial Average (1970-2008) with the 12-26 week MACD expressed as %. Vertical dashed lines indicate the seven occasions when MACD% climbed from below to above -3%. The 1973-1974 bear market, crash of 1987 and 2007-2008 market correction are labeled A,B,C (respectively) as in Figure 2.

The concepts discussed here are covered in more detail in Gerald Appel's book, "Technical Analysis: Power Tools for Active Investors" (2005).

Gerald Appel is the President of Signalert Corporation of Great Neck, New York, an SEC-registered investment advisory firm. He is the inventor of the MACD and the author of a number of groundbreaking investment books, the most recent of which is Beating the Market Three Months at a Time (2008), which he co-authored with Marvin Appel.

Marvin Appel is the CEO of Appel Asset Management Corporation, also an SEC-registered investment advisory firm in Great Neck. He is a renowned expert in exchange-traded funds and the editor of the well-regarded investment newsletter Systems and Forecasts. For more information about the material discussed in this article, please visit www.systemsandforecasts.com.