Trading The MACD Histogram, Part 1

MACD-Histogram offers a deeper insight into the balance of power between bulls and bears than the original MACD. It shows not only whether bulls or bears are in control, but also whether they are growing stronger or weaker. It is one of the best tools available to a market technician.

And later, under the heading "The strongest signal in technical analysis":

Divergences between MACD-Histogram and prices occur only a few times a year in any given market, but they give some of the most powerful messages in technical analysis. These divergences identify major turning points and give "extra-strength" buy or sell signals. They do not occur at every important top and bottom, but when you see one, you know that a major reversal is probably at hand.

If that's not an endorsement, then I don't know what is. I'm not sure if Elder feels as strongly about the "MACD-Histogram" today in 2006 as he did back in 1993 when Trading For A Living was completed, but the indicator itself continues to have adherents. For example, Raghee Horner, forex trader and author, has used the MACDH as a general indicator to determine whether a market is bullish and ripe for buying or bearish and ripe for selling.

I've written about the MACD histogram before for Working-Money.com, particularly about what I referred to as "MACDH extremes," which can often be helpful in determining intermediate-term direction after major market moves and when dealing with consolidations. Here, however, I want to talk about a few of the basic ways that traders can and have used the MACD histogram in order to trigger trade entries as well as determining directionality.

The MACD was developed by trader Gerald Appel, who also publishes the Systems and Forecasts newsletter. Although the MACD appears with two lines that converge and diverge relative to each other, the indicator is actually created using three lines. Writing in his book The Visual Investor, John Murphy explains how the MACD is constructed:

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 line: and the slower signal line.

Buy and sell signals using the MACD are similar to those using other pairs of moving averages. When the fast MACD line crosses above the slow signal line, a buy signal has been issued. Conversely, when the fast MACD line crosses below the slow signal line, a sell signal has been issued. Approaching the MACD this way means that the trader will tend to be on the right side of the trend when following the signals. As I'll show later, there can be other tools that traders will use — from moving averages to trendlines to the MACD histogram — to determine whether the trend they may have received a signal to follow is one of significant duration, as in a bullish or bearish context. (See Figure 1.)

FIGURE 1: SEARS HOLDINGS CORP., DAILY. The basic MACD is shown here, along with one of the more common buy signals that can be derived from it. The highlighted section in the indicator window shows where the faster MACD line (in blue) crossed over the slower signal line (in red). The highlighted session shows the candlestick above which the long trade would be initiated.

There are two other ways that the MACD can be used. One is as an oscillator. Insofar as the two lines — the MACD line and the signal line — both operate above and below a zero line, some traders have used the MACD to indicate oversold market conditions that can be bought (both lines below the zero line) as well as overbought market conditions that can be sold (both lines above the zero line).

Murphy points out that some traders combine the crossover and oscillator aspects of the MACD by looking for bullish crosses (remember, the MACD line crossing above the signal line) below the zero line indicating a buy and bearish crosses (the MACD line crossing below signal line) above the zero line as indicating a sell.

Traders have also used the MACD to spot divergences. In much the same way that traders use oscillators like the RSI (relative strength index) and stochastics, traders look for instances when the MACD makes a lower high while a market is making a higher high (a negative divergence) or when the MACD makes a higher low while a market is making a lower low (a positive divergence).

So where does the histogram fit into all of this? According to Murphy, in a way that makes it even better. He writes:

As good as the MACD indicator is in the form just described, there's a way to make it even better. That technique is called the :MACD histogram. The MACD histogram will provide even earlier warnings of potential trend changes and greatly enhances the value of the indicator. Since the histogram shows the MACD crossover signals (in a slightly different way), nothing is lost in its use. What is gained is a way to generate action signals much sooner.

As noted, this ability to create "action signals" ultimately won me over to the cause of the MACDH. The histogram simply represents the difference between the MACD line and the signal line, and plots it as a series of vertical bars. Other indicators such as the commodity channel index (CCI) can also be plotted as histograms. A positive histogram, with vertical bars above the zero line, indicates a market in which the MACD fast line (the MACD line) is above the slow line (the signal line). A negative histogram, by contrast, with vertical bars extending below the zero line, indicates a market in which the MACD line is below the signal line.

When these two lines are close or are converging, the histogram bars will be shallow and small. When these two lines are diverging, moving away from each other, the histogram bars will increase in length — above or below the zero line. Another factor key in creating action signals is what Elder points out as the slope of the MACD histogram. He writes:

The slope of MACD-Histogram is defined by the relationship between any two neighboring bars. If the last bar is higher (like the height of letters m-M), the slope of the MACD-Histogram is up. If the last bar is lower (like the depth of letters P-p), then the slope of MACD-Histogram is down.

BREAKOUTS AND CONTINUATIONS
Many — though not all — of the signals created by the MACD histogram are related to changes in the slope of the indicator. In fact, the primary signal in my MACDH trading methodology involves just such a change of slope or, more accurately, involves using a temporary change in slope (a histogram pullback or bounce) in order to create a buy signal. I've called these signals "L1" and "S1" (primary long and primary short) and remain my favorite signals using the histogram. Although Elder writes that weekly signals are less frequent and perhaps more reliable than daily ones, I've found that trades using the L1 and S1 methods have been confirmed by buy and sell signals using other methods such as the TRIX as well as often simply proving in hindsight to have marked excellent entry points in trends. (See Figure 2.)

FIGURE 2: GOLDMAN SACHS, DAILY. An example of an oversold L1 breakout trading using the MACD histogram. Here, the histogram is forming the "P-p-P" pattern, which gives a buy signal with the third bar of the pattern. This particular pattern happens to appear at the end of a brief, largely sideways consolidation.

The key point is that the middle value or histogram bar is either shorter (in the case of a histogram above the zero line) or longer (in the case of a histogram below the zero line) than the pair of histogram bars that surround it on either side.

Conversely, to the short side, a pattern like "m-M-m," "p-P-p," or, again numerically, reading -5, then -3.5, then -6. The session that received the "-6" would be the trigger session. Here, the difference is that the trader would be looking to sell or get short below the low of that "trigger session." See Figure 3.

FIGURE 3: MASTERCARD, DAILY. Another example of the L1 "breakout" MACDH trade. The highlighted histogram bars show a "M-m-M" pattern, which produces a buy signal above the high of the day (or session) that the "M-m-M" pattern is completed. Also called the "trigger," that session is highlighted. Going long the day after the trigger session resulted in solid gains within a few days.

While this approach has been worthwhile, there are other methods (such as the BOSO method I wrote about a year ago) that do as good a job or better of tracking markets that appear unwilling to provide traders with a pullback (in a rising market) or a bounce (in a falling market) from which to gain a superior entry. Nevertheless, the continuation trade is one worth keeping in mind when a market advance appears well under way, and bargain entries prove themselves hard to come by.

In part II, I will look at trading histogram divergences, how to trade crosses of the zero line, specific entry targeting, and exit strategies.

SUGGESTED READING
Achelis, Steven B. [1995]. Technical Analysis From A To Z, Irwin Professional Publishing.
Appel, Gerald [1985]. The Moving Average Convergence-Divergence Trading Method, Advanced Version, Scientific Investment Systems.
Elder, Alexander [1993]. Trading For A Living, John Wiley & Sons.
Gifford, Elli [1995]. The Investor's Guide To Technical Analysis, Financial Times/Pitman Publishing.
Horner, Raghee [2005]. ForeX Trading For Maximum Profit, John Wiley & Sons.
Kahn, Michael [2006]. Technical Analysis: Plain And Simple, Financial Times/Pitman Publishing.
Murphy, John J. [1996]. The Visual Investor, John Wiley & Sons.