Indicators (Part 2)

15.1 Moving Average Convergence and Divergence (MACD)

The Moving Average Convergence and Divergence (MACD) indicator was developed by Gerald Appel in the late seventies. Traders consider MACD as the grand old daddy of indicators. Though invented in the seventies, MACD is still considered as one of the most reliable indicators by momentum traders.

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 a divergence occurs when the moving averages move away from each other.

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.

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

Let us go through the table starting from left:

1. We have the dates, starting from 1^st Jan 2014
2. Next to the dates we have the closing price of Nifty
3. We leave the first 12 data points (closing price of Nifty) to calculate the 12 day EMA
4. We then leave the first 26 data points to calculate the 26 day EMA
5. Once we have both 12 and 26 day EMA running parallel to each other (6^th Feb 2014) we calculate the MACD value
6. MACD value = [12 day EMA – 26 day EMA]. For example on 6^th Feb 2014, 12 day EMA was 6153, and 26 day EMA was 6198, hence the MACD would be 6153-6198 = – 45

When we calculate the MACD value over a series of 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	160

Given the MACD value, lets try and find the answer for few obvious questions:

1. What does a negative MACD value indicate?
2. What does a positive MACD value indicate?
3. 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 then the MACD value is +160. Now, 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 longer term only when the stock price is trending upwards. Also, do remember, the shorter term average will always be more reactive to the current market price than the longer term average. Hence 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, 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 chart of the MACD value, often referred to as the MACD line.

The following is the MACD line chart of Nifty for data points starting from 1^st Jan 2014 to 18^th Aug 2014.

As you can see the MACD line oscillates over a central zero line. This is also called the ‘Center line’. The basic interpretation of the MACD indicator is that:

1. When the MACD Line crosses the center line from the negative territory to positive territory, it means there is 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 27^th Feb
2. When the MACD line crosses the center line from positive territory to the negative territory it means there is 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 instance during which the MACD almost turned negative (8^th May, and 24^th July) but the MACD just stopped at the zero line and reversed directions

Traders generally argue that while waiting for the MACD line to crossover the center line a bulk of the move 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 a exponential moving average (EMA) of the MACD line. If you think about this, we now have two lines:

1. A MACD line
2. A 9 day EMA of the MACD line, also called the signal line

With these two lines, a trader can follow a simple 2 line crossover strategy as discussed in the moving averages chapter, and no longer wait for the center line cross over.

1. The sentiment is bullish when the  MACD line crosses the 9 day EMA wherein MACD line is greater than the 9 day EMA. When this happens, the trader should look at buying opportunities
2. 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:

1. 12 day EMA of closing prices
2. 26 day EMA of closing prices
3. MACD line (12D EMA – 26D EMA) represented by the black line
4. 9 day EMA of the MACD line represented by the red line

The vertical lines on the chart highlight the crossover points on the chart where a signal to either buy or sell has 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 2^nd vertical line from left, points to a crossover where the MACD line lies above the signal line, hence one 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 the markets are 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 day, 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 Bands

Introduced by John Bollinger in the 1980s, Bollinger bands (BB) is perhaps one of the most useful indicators used in technical analysis. BB are 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:

1. Middle line which is The 20 day simple moving average of the closing prices
2. An upper band – this is the +2 standard deviation of the middle line
3. A lower band – this is the -2 standard deviation of the middle line

The standard deviation (SD) is a statistical concept; which measures the variance of a particular variable from its average. In finance, the standard deviation of the stock price represents the volatility of a stock. For example, if the standard deviation of a stock is 12%, it is as good as saying that the volatility of the stock is 12%.

In BB, the standard deviation is applied on the 20 day SMA. The upper band indicates the +2 SD. By using a +2 SD, we simply 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:

1. 20 day SMA = 7800
2. Upper band = 7950
3. Lower band = 7650

Statistically speaking, the current market price should hover around the average price of 7800. However, if the current market price is around 7950, then it is considered expensive with respect to 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 with respect to the average prices, and hence one should look at buying opportunities with and expectation 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,

The central black line is the 20 day SMA. The two red lines placed above and below the black like are the +2 SD, and -2SD. The idea is to short the stock when the price touches the upper band with an expectation that it will revert to average. Likewise one can go long when the price touches the lower band with an expectation it will revert to the average.

I have highlighted using a down arrow all the sell signals BB generated, while most of the signals worked quite well, there was a phase when the price stuck to the upper band. In fact the price continued to drift higher, and therefore even the upper band expanded. This is called an envelope expansion.

The BB’s upper and lower band together forms an envelope. The envelope expands, whenever the price drifts in a particular direction indicating a strong momentum. The BB signal fails when there is an envelope expansion. This leads us to an important conclusion; BB works well in sideways markets, and fails in a trending market.

Personally whenever, I use BB I expect the trade to start working in my favor almost immediately. If it does not, I start validating the possibility of an envelope expansion.

15.3 – Other Indicators

There are numerous other technical indicators, and the list is endless. The question is, should you know all these indicators to be a successful trader? The answer is a simple no. Technical indicators are good to know, but they by no means should be your main tool of analysis.

I have personally met many aspiring traders who spend a lot of time, and energy learning different indicators, but this in the long run is futile. The working knowledge of few basic indicators, such as the ones discussed in this module are sufficient.

15.4 – The Checklist

In the previous chapters, we started building a checklist that acts as a guiding force behind the trader’s decision to buy or sell. It is time to revisit that checklist.

The indicators act as tool which the traders can use to confirm their trading decisions, it is worthwhile to check what the indicators are conveying before placing a buy or a sell order. While the dependence on indicators is not as much S&R, volumes or candlestick patterns, it is always good to know what the basic indicators are suggesting. For this reason, I would recommend adding indicators in the checklist, but with a twist to it. I will explain the twist in a bit, but before that let us reproduce the updated checklist.

1. The stock should form a recognizable candlestick pattern
2. S&R should confirm to the trade. The stoploss price should be around S&R
   1. For a long trade, the low of the pattern should be around the support
   2. For a short trade, the high of the pattern should be around the resistance
3. Volumes should confirm
   1. Ensure above average volumes on both buy and sell day
   2. Low volumes are not encouraging, hence do feel free to hesitate while taking trade where the volumes are low
4. Indicators should confirm
   1. Scale the size higher if the confirm
   2. If they don’t confirm, go ahead with the original plan

The sub bullet points under indicators are where the twist lies.

Now, hypothetically imagine a situation where you are looking at opportunity to buy shares of Karnataka Bank Limited. On a particular day, Karnataka Bank has formed a bullish hammer, assume everything ticks on the checklist:

1. Bullish hammer is a recognizable candlestick pattern
2. The low of the bullish hammer also coincides with the support
3. The volumes are above average
4. There is also an MACD crossover (signal line turns greater than the MACD line)

With all four checklist points being ticked off I would be very glad to buy Karnataka Bank. Hence I place an order to buy, let us say for 500 shares.

However, imagine a situation where the first 3 checklist conditions are met but the 4^th condition (indicators should confirm) is not satisfied. What do you think I should do?

I would still go ahead and buy, but instead of 500 shares, I’d probably buy 300 shares.

This should hopefully convey to you how I tend to (and advocate) the use of indicators.

When Indicators confirm, I increase my bet size, but when Indicators don’t confirm I still go ahead with my decision to buy, but I scale down my bet size.

However I would not do this with the first three checklist points. For example, if the low of the bullish hammer does not coincide in and around the support, then I’ll really reconsider my plan to buy the stock; in fact I may skip the opportunity, and look for another opportunity.

But I do not treat the indicators with the same conviction. It is always good to know what indicators convey, but I don’t base my decisions on that. If the indicators confirm, I increase the bet size, if they don’t, I still go ahead with my original game plan.

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Key takeaways from this chapter

1. A MACD is a trend following system
2. MACD consists of a 12 Day, 26 day EMA
3. MACD line is 12d EMA – 26d EMA
4. Signal line is the 9 day SMA of the MACD line
5. A crossover strategy can be applied between MACD Line, and the signal line
6. The Bollinger band captures the volatility. It has a 20 day average, a +2 SD, and a -2 SD
7. One can short when the current price is at +2SD with an expectation that the price reverts to the average
8. One can go long when the current price is at -2SD with an expectation that the price reverts to the average
9. BB works well in a sideways market. In a trending market the BB’s envelope expands, and generates many false signals
10. Indicators are good to know, but it should not be treated as the single source for decision making.