Moving averages: A reliable tool

But cross-verification would be needed with price breakouts.

Moving Average Convergence/Divergence (MACD) is one of the simplest and most reliable indicators available. MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics. These lagging indicators are turned into a momentum oscillator by subtracting the longer moving average from the shorter moving average. The resulting plot forms a line that oscillates above and below zero, without any upper or lower limits. Exponential averages of 12 and 26 are the famous parameters to construct MACD. A 9-day EMA of MACD is also plotted alongside to act as a trigger line.

MACD generates bullish signals from three main sources:

 

 

 

Positive Divergence 
 

Bullish Moving Average Crossover 
 

Bullish Centre line Crossover

POSITIVE DIVERGENCE
A positive divergence occurs when MACD begins to advance and the security is still in a downtrend and makes a lower low. MACD can either form as a series of higher Lows or a second Low that is higher than the previous Low. Positive divergences are probably the least common of the three signals, but are usually the most reliable, and lead to the biggest moves.

BULLISH MOVING AVERAGE CROSSOVER
This occurs when MACD moves above its 9-day EMA, or trigger line. BMACs are probably the most common signals and the least reliable. If not used in conjunction with other technical analysis tools, these crossovers can lead to whipsaws and many false signals.

BULLISH CENTRE LINE CROSSOVER
This occurs when MACD moves above the zero line and into positive territory. This is a clear indication that momentum has changed from negative to positive or from bearish to bullish. After a Positive Divergence and Bullish Moving Average Crossover, the Bullish Centre line Crossover can act as a confirmation signal. Of the three signals, moving average crossovers are probably the second most common signals.

Let us take a live example of an MACD oscillator applied on the Infosys weekly chart. Here we see both bullish and bearish MACD signals during different time periods, cross-verified with the price breakouts by applying trendlines on the chart. On September 19, 2008, the weekly MACD had given a bearish centre line crossover, coupled with the bearish trendline breakout when the stock was trading around 1,570. Thereafter, the stock tumbled 33 per cent, reaching the level of 1,040, in a span of just three weeks.

On April 9, 2009, the weekly MACD had given a bullish centre line crossover, coupled with the bullish trendline breakout when stock was trading around 1,420. Had one gone long in Infosys at 1,420, he would still be in a holding position as on date, yielding a return of 70 per cent in the span of 25 weeks.

MACD BEARISH SIGNALS
MACD generates bearish signals from three main sources. These signals are mirror reflections of the bullish signals:

Negative Divergence 
 

Bearish Moving Average Crossover 
 

Bearish Centre line Crossover

Take a live example of the MACD oscillator applied on the Ambuja weekly chart. Here we see the formation of negative divergence on November 30, 2007, when the stock price made a higher top of 161 (Previous Top,150) coupled with the MACD lower top. A negative divergence was a red flag sign. However, the sell signal was confirmed when the trendline in the stock price was breached, along with the bearish MACD centre line crossover, when the stock was trading at 117. Thereafter, the stock tumbled by 63 per cent, reaching the level of 43, followed by a positive divergence formed on October 24, 2008. Looking at the positive divergence, one could have at least exited from the shorts positions and initiated a fresh long, once the downward sloping trendline was surpassed at 73-odd levels. The stock went up by 52 per cent, reaching the level of 111.50 on August 7, 2009.

CROSS-VERIFICATION IMPORTANT
Before taking a bullish or bearish view only on the basis of indications provided by the MACD, one should always cross-verify the same with price breakouts for taking a final call. Price breakouts can be confirmed by using crucial support-resistance levels, plotted either by historical prices or a tool-like trendline. By doing this, one can reduce the chances of getting false breakouts.

The writer is director and head of research, Anagram Capital