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MACD HISTOGRAM
In last week's StreetAuthority
Swing Trader we discussed the importance of MACD. You saw
that an important component of a successful trading system is to combine
weekly and daily MACD signals. You can do so by taking the daily signals
that are in accordance with both the weekly MACD and the overall trend
(as measured by the 30- or 40-week moving average).
MACD can be made even more useful by incorporating a
related indicator -- the MACD histogram. Thomas Aspray described the
histogram in 1986. Like MACD, it oscillates around a zero line. But
while MACD is an indicator based on moving averages, the histogram is an
indicator of an indicator -- the MACD itself.
What the histogram shows in graphic form is the difference
between the main MACD line (the 12-26 line) and the nine-period trigger
line. This difference is then plotted on a scale to form a histogram,
defined as a series of vertical lines. The higher the lines
"grow" above the histogram's zero line, the stronger the price
momentum and the more bullish the trend. The further the lines decline
below the zero line, the stronger the negative the trend and the more
downside pressure there is. When the MACD indicator itself issues a buy
or sell signal, then the histogram is always at its own zero line.
Although you can derive the same information by
eyeballing the underlying MACD indicator, the histogram does the job for
you, allowing you to spend your full energy on technical analysis.
There are two important ways to use the histogram to
generate trading signals. First, the histogram tells you when momentum
is beginning to wane. Since a key principle of technical analysis is
that momentum precedes price, the histogram gives the technician an
early warning that prices may be about to reverse course.
The chart above is the weekly chart of the S&P 500
index with the 40, 12 and 26-week moving averages shown, as well as MACD
and the histogram. First, note that in one year of trading, there have
been only three crosses of this histogram above and below the zero line,
reflecting the three underlying MACD signals in this time frame.
Clearly, these signals are infrequent enough to be carefully noted.
Second, note the negative momentum peak in mid-July
and the positive momentum peak in late December. As a trader, one should
avoid taking a short position at the peak of negative momentum and a
long position at the peak of positive momentum.
The histogram is thus an early warning indicator,
telling the trader that a momentum peak has been reached and that a peak
in price may not be far away. Given the overall downtrend as measured by
the 40-week moving average, going long at the momentum peak would be a
serious error and could prove costly.
The histogram also gives important divergence signals.
Negative divergence occurs when prices rally to a new high or back to
approximately the same level and the histogram is lower. Positive
divergence occurs when prices reach a lower low, but the MACD histogram
is at a higher level.
The best example of histogram divergence on this chart
can be seen when comparing the July and October lows, both of which
occurred at around S&P 775. Note that the first low occurred at
about –20 on the histogram scale, whereas the second low was very
close to the 0 line. The trader who perceived this signal would be on
the alert for a price reversal. When the actual MACD crossover occurred
in early October, the opportunity could have been acted on without
hesitation.
The MACD histogram combines well with MACD to give you
a trend-following and momentum indicator all in one. It is an
indispensable tool of technical analysis. Next week we will explore the
idea of MACD divergence in more detail.
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