MACD stands for Moving Average Convergence-Divergence. This indicator was developed by Gerald Appel, who combined three moving averages into two MACD lines. We can enhance MACD by plotting it as a histogram, reflecting the distance between those lines. It helps identify trends and rate the power of bulls and bears. It is one of the best tools in technical analysis for catching reversals.

Before we use any indicator, we must understand how it is constructed and what it measures. As noted before, each price represents a momen tary consensus of value of stock market participants. A moving average shows us the average consensus of value during a selected period of time. A fast moving average reflects the average consensus during a short period of time, and a slow moving average during a longer period of time. MACD Histogram measures changes in consensus by tracking the spread between fast and slow moving averages.

Appel used three exponential moving averages to create MACD:

1. Calculate a 12-day EMA of closing prices.

2. Calculate a 26-day EMA of closing prices.

3. Subtract the 26-day EMA from the 12-day EMA-this is the fast or MACD line.

4. Calculate a 9-day EMA of the fast line-this is the slow or signal line.

The values of 12, 26, and 9 have become standard numbers, used as defaults in most software packages. My testing shows that changing these values has little impact on MACD signals, unless you go way out on a limb and seriously distort their relationships by more than doubling one but not the others. If you track some market value and do not have the time to customize your indicators, you can accept the default values of MACD. If you follow only a few markets, it makes sense to experiment with higher and lower MACD values to find those that more closely track turning points in your stocks or futures. If your software doesn't include MACD, you may use two EMAs (for example, 12-day and 26-day) in lieu of the fast and slow MACD lines. Then apply the MACD-Histogram formula, on the next page, to the spread between those two averages.

The fast line of MACD reflects a short-term consensus of value, while the slow signal line reflects a longer-term consensus. When the fast line rises above the slow line, it shows that market participants are becoming more bullish. When bulls are becoming stronger, it is a good time to get long. When the fast line of MACD falls below the slow line, it shows that market participants are becoming bearish. When bears become stronger, it is a good

time to get short. MACD lines follow trends, and their crossovers mark trend reversals. Like all trend-following indicators, they work best when markets are moving but lead to whipsaws during choppy periods. We can make MACD more useful by converting it into MACD-Histogram.

MACD-Histogram = Fast MACD line - Slow signal line

MACD-Histogram measures the spread between short-term and long-term moving averages and plots it as a histogram. It reflects the difference between short-term and long-term consensus of value. Some software packages include MACD lines but not MACD-Histogram. In that case, run MACD lines, return to the menu and run an indicator called spread (or similar), which should measure the spread between the two lines and plot it as a histogram.

When you look at MACD lines, their spread may appear tiny, but MACDHistogram rescales it to fit the screen. The slope of MACD-Histogram shows whether bulls or bears are growing stronger. That slope is defined by the relationship between the two latest bars. When the bars of MACD-Histogram rise (like the pattern of letters g-G), they show that the crowd is becoming bullish-it is a good time to be long. When the slope of MACD-Histogram declines (like in letters Q-q), it shows that the crowd is becoming bearish- it is a good time to be short.

Markets run on a two-party system-the bulls and the bears. When MACD-Histogram rises, it shows that bulls are becoming stronger, and when it declines, it shows that bears are becoming stronger. MACD-Histogram helps you bet on the winning party and sell short the opposition.

The Strongest Signal MACD-Histogram gives two types of signals. One is ordinary, and we see it at every bar-it is the slope of MACDHistogram. An uptick of MACD-Histogram shows that bulls are stronger than they were at the previous bar, and a downtick shows that bears are gaining. Those upticks and downticks provide minor buy and sell signals, but we shouldn't read too much into them. Markets do not move in straight lines, and it's normal for MACD-Histogram to keep ticking up and down.

The other signal occurs rarely, only a couple of times per year on the daily charts of most markets, but it's worth waiting for because it is the strongest signal in technical analysis. That signal is a divergence between the peaks and bottoms of price and MACD-Histogram. A divergence occurs when the trend of price highs and lows goes one way and the trend of tops and bottoms in MACD-Histogram goes the opposite way. Those patterns take several weeks or even more than a month to develop on the daily charts.

A bullish divergence occurs when prices trace a bottom, rally, and then sink to a new low. At the same time MACD-Histogram traces a different pattern. When it rallies from its first bottom, that rally lifts it above the zero line, "breaking the back of the bear." When prices sink to a new low, MACD-Histogram declines to a more shallow bottom. At that point, prices are lower, but the bottom of MACD-Histogram is higher, showing that bears are weaker and the downtrend is ready for a reversal. MACDHistogram gives a buy signal when it ticks up from its second bottom.

Occasionally, the second bottom is followed by a third. This is why traders must use stops and proper money management. There are no cer tainties in the markets, only probabilities. Even a reliable pattern such as a divergence of MACD-Histogram fails occasionally, which is why we must exit if prices fall below their second bottom. We must preserve our trad ing capital and reenter when MACD-Histogram ticks up from its third bottom, as long as it is higher than the first.

A bearish divergence occurs when prices rise to a new high, decline, and then rise to a higher peak. MACD-Histogram gives the first sign of trouble when it breaks below its zero line during the decline from its first peak. When prices reach a higher high, MACD-Histogram rises to a much lower high. It shows that bulls are weaker, and prices are rising simply out of inertia and are ready to reverse.

The Hound of the Baskervilles MACD-Histogram offers traders what x-rays offer doctors, showing the strength or weakness of the bone below the surface of the skin. Bulls or bears may appear powerful when prices reach a new extreme, but a divergence of MACD-Histogram shows that the dominant party is becoming weak and prices are ready to reverse.

Go long when MACD-Histogram traces a bullish divergence, that is, when prices fall to a new low while the indicator ticks up from a more shal-low low. Get long after MACD-Histogram ticks up from its second bottom.

A bottom that is more shallow than the preceding one shows that bears have grown weaker, and the uptick tells us that bulls are taking over. Place a protective stop below the latest bottom. Rallies from bullish divergences tend to be very powerful, but you must always use protection in case a signal does not work out.

An aggressive trader can make that stop "stop-and reverse," meaning that if stopped out of a long position, he will reverse and go short. When a super-strong signal doesn't pan out, it shows that something is fundamentally changing below the surface of the market. If you buy on the strongest signal in technical analysis and then your stop gets hit, it means that bears are especially strong, making it worthwhile to sell short. Reversing positions from long to short is usually not the best idea, but the failure of a divergence of MACD-Histogram is an exception.

I call this a Hound of the Baskervilles signal, after a story by Sir Arthur Conan Doyle. Sherlock Holmes was called to investigate a murder on a country estate. His clue came from the fact that the family dog did not bark while the crime was being committed. That indicated the dog knew the criminal, and the murder was an inside job. Sherlock Holmes received his signal not from the action but from the lack of expected action. When a divergence of MACD-Histogram fails to produce a reversal, it gives a Hound of the Baskervilles signal.

Go short when the MACD-Histogram traces a bearish divergence, that is, when prices rise to a new high but the indicator ticks down from a lower peak. When the crowd gets on its hind legs and roars, it is tempting to throw caution to the wind, close our eyes, and buy. When the crowd be-comes manic, it is hard to remain cool, but an intelligent trader looks for MACD-Histogram divergences. If prices rally, decline, and then rally to a higher level, but MACD-Histogram rallies, falls below its zero line, breaking the back of the bull, and rallies again, but to a lower level, it creates a bearish divergence. It shows that bulls have grown weaker, the stock is rising out of inertia, and as soon as that inertia runs out, the stock is likely to collapse.

MACD-Histogram flashes a signal to go short when it ticks down from its second peak. Once short, place a stop above the latest rally peak. Placing stops when shorting near the tops is notoriously difficult because of high volatility. Trading strategy smaller positions allows you to place wider stops.

Divergences between MACD-Histogram and prices on the daily charts are almost always worth trading money. Divergences on the weekly charts usu ally mark transitions between bull and bear markets.

When MACD-Histogram reaches a new multi-month peak, it indicates that bulls are extremely strong, and the corresponding price peak is likely to be retested or exceeded. When MACD-Histogram falls to a new multi month low, it shows that bears are extremely strong, and the corresponding price low is likely to be retested or exceeded.

When MACD-Histogram rises to a new record peak, it shows a terrific splash of bullish enthusiasm. Even if bulls pause to catch their breath, the upside inertia is so strong that the rally is likely to resume after a pause. When MACD-Histogram drops to a new low, it shows that bears are extremely strong. Even if bulls manage to stage a rally, the sheer downside inertia is likely to drive the market to retest or exceed its low.

MACD-Histogram works like headlights on a car-it lights up a stretch of the road ahead. It doesn't show you the entire way home, but lets you see far enough so that driving at a normal speed you can prepare for the twists and turns ahead.