Technical Indicators: Exponential Moving Averages and MACD
Another moving average that is often used when evaluating potential stocks is the exponential moving average (EMA). EMAs are different from the simple moving averages that we have discussed in that they are exponentially weighted towards recent closing prices. As a result, an EMA is more sensitive to price changes. This makes using EMAs very helpful for looking at a stock’s current trend or momentum but not quite as reliable as a baseline for judging relative “highness” or “lowness” which we saw was the usual use for SMAs.
The most popular use of EMA is within the MACD, or Moving Average Convergence/Divergence. There are many flavors of this indicator, but the one that you will see most often is the one which was developed by Gerald Appel in the 1960s. For this indicator, we will see two series (curves/lines) graphed on a graph seperate from the price chart. The primary curve is a graph of the difference between the 26-day and the 12-day EMA. The other curve is the graph of the 9-day EMA of the primary curve, the “signal line”. Signals are triggered when one curve crosses the other (converges) and then begins to move away from the other curve (diverges). On bigcharts.com, you will find this indicator as part of the “Lower Indicators” group. And the graph will likely look much like the one below.
As you can see, MACD is indeed graphed on a seperate chart. While the x-axis is still that of the time passed, the y-axis is now counting numbers positive and negative. The position of the curves around 0, positive or negative, is a signal of whether or not the 12-day EMA is above the 26-day EMA and to what degree it is above. When positive, it is a sign of upward momentum and when negative it is a sign of downward momentum for the stock’s price. Bigcharts.com also gives us a handy graph of how much our two curves are apart from each other (the black area graphs centered around the 0 line), a measure of nominal divergence.
What we are looking for is a positive diverengce but not one which is out of the typical range. When the divergence gets extreme, it is usually a sign that the stock is overbought and will soon return to normal levels. Another thing that we look at is crossovers of the primary curve over the signal line. When it crosses above, this is a signal of the start of an upward trend. When it crosses below, a signal of a downward trend. We also look for another kind of divergence which is different from the divergence of the two lines on the MACD curve. The other kind of divergence is the divergence of the stock’s price from the MACD curves. If the stock makes a new high without the MACD making a high as well, we take this as a “negative divergence” which is a sign that the upward trend is reversing and it may be time to sell. There is also a “positive divergence” which would act as a buy indicator, but is seen more rarely.
It is difficult to talk about all the uses of MACD in one blog post, and if you want to learn more I recommend checking out this tutorial from stockcharts.com. It has many great example graphs and will really improve your understanding of MACD. It also has a very good run down of the benefits and drawbacks of MACD. As usual, since it is based on moving averages, the MACD is really only good for nearer term analysis (days/weeks to months) and not for long-term analysis of a stock’s potential. When used properly, it often serves as a foundational tool for technical analysis and is invaluable for spotting and confirming trends.
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