The Visual Investor: How to Spot Market Trends, Second Edition

CHAPTER 6

How to Have the Best of Both Worlds

The most critical problem facing the visual investor is knowing when to emphasize each class of indicator. During a strong trending period, moving averages will outperform most other indicators. During choppy market periods, when prices swing back and forth in an essentially trendless manner, oscillators are much better than moving averages. Fortunately, there is one indicator that combines the best of both worlds in the sense that it is both a trend-following system and an oscillator. It employs moving averages to generate trend-following signals, but also helps to determine when a trend is overbought or oversold. It is also helpful in spotting divergences, one of the greatest strengths of an oscillator. After showing you how to use it, we’ll show you an even better way to use it. We’re speaking of the moving average convergence divergence (MACD) indicator.

MACD CONSTRUCTION

This indicator, developed by Gerald Appel, utilizes three moving averages in its construction although only two lines are shown on the chart. The first line (called the MACD line) is the difference between two exponentially smoothed moving averages of the price (usually 12 and 26 periods). The computer subtracts the longer average (26) from the shorter (12) to obtain the MACD line. A moving average (usually nine periods) is then used to smooth the MACD line to form a second (signal) line. The result is that two lines are shown on the chart, the faster MACD ...