Moving averages are among the most widely used indicators in technical analysis. They come in various sizes, shapes and forms, as the previous article in this series explained, and they are used many different ways. Perhaps the most useful is Moving Average Convergence-Divergence, better known as MACD, which uses three exponential moving averages (EMAs). It can be used for various time periods, but some traders find it most useful on daily and weekly charts as an indicator of trend continuation or reversal.

MACD involves several steps. First, calculate two EMAs of closing prices. Typically, 12 and 26 periods are used as defaults in technical analysis software, but you may want to try other lengths. Subtract the 26-day EMA from the 12-day EMA. The difference is the fast line plotted as a solid line (or, in the case of our chart of Crude Oil futures, a red line).

Then, calculate another EMA of the differences between the 12- and 26-period EMAs. Usually, 9 periods is the default for this EMA. This is the slow line plotted as a dashed line (or, on the Crude Oil chart, a blue dashed line). Fortunately, most technical analysis software packages include the MACD indicator and can perform these functions on your computer much more quickly and accurately than you can manually.

Now, you are ready to use MACD to find trading signals. One way to do this is to use crossover methods frequently used for moving averages. When the fast, solid line (the difference between the 12- and 26-period EMAs) crosses above the slow, dashed line (9-day EMA of the difference between the other two EMAs), you buy; when the fast line crosses below the slow line, you sell.

A better representation of what is happening in the market is a MACD histogram. Each bar represents the difference between the fast and slow EMA lines; the zero line indicates that the fast and slow EMA readings are the same. If the bar is rising, buying pressure is increasing. If the bar is declining, selling pressure is increasing. The farther the bar gets above the zero line, the stronger the market; the farther the bar drops below the zero line, the weaker the market. Some traders will wait for the bars to cross the zero line to establish a position; others will buy or sell when they see the bars turn and begin to establish a pattern in the opposite direction.

Used in this way, MACD can have two functions: As a momentum oscillator, suggesting when turns may be taking place (although it is not based on a 0 – 100 scale as popular oscillators such as stochastics are) and as a trend-following indicator, showing when trends are strengthening. Every bar provides a clue about the market. If it is higher than the previous bar, buying is more dominant; if it is lower, selling is more dominant.

Another popular use of the MACD histogram is its overall pattern, especially when its movement diverges from the price pattern. In many cases, prices and indicators track together on a chart. Occasionally, however, prices will reach a high, retreat and then move on to a higher high while MACD makes the first high but then fails to make a new high on the second attempt. This divergence between the two indicates that, even though prices may have been able to push to new highs, the momentum reflected in the MACD is weakening and is not likely to keep driving prices higher. You could enter a new short position or exit a long position. One example of divergence at a bottom is indicated on the Crude Oil chart in August when prices made a new low but the MACD histogram did not. That turned out to be a good clue that something was changing, leading to a rally of more than 10 points.