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MACD Confirmation and Divergence in 2015


After the August 2015 sell-off the broad-based indexes found support and pivoted higher before month-end. However, by the latter half of September 2015 more selling pressure came into the market pushing the price of the S&P 500 Index (SPX) down to a near retest of its August 2015 lows while moving the value of the Russell 2000 Index (RUT) to new lows.  Even though the price action of these two indexes differed, the behavior of each respective Moving Average Convergence Divergence (MACD) Indicator was the same. Specifically, both MACD’s formed a higher low in late September 2015 after the August 2015 low was formed. Given the aforementioned similarities, MACD conveyed a powerful underlying message. In the case of RUT we observe that divergence formed between the lows of the price and the lows of the MACD lines. That is, as RUT formed a lower-low by the end of September 2015 its MACD was making a higher-low which is indicative of future price strength. MACD is categorized as a trend indicator and drawing trendlines between lows and highs of MACD can help identify the direction of a price trend. Additionally, divergence between an index and its indicator is often a reliable sign of an upcoming price move. In this case, after the divergence, the price of RUT followed through to reach new multi-month highs by year-end 2015. This divergence can be classified as bullish divergence since after RUT and MACD formed a lower-low, MACD went on to make a higher-low (i.e. bullish trend development) while RUT diverged by making a lower low. Alexander Elder notes, “Bullish divergences occur toward the end of downtrends and often precede sharp price rallies.” (The New Trading for a Living, pg. 86) A long position could have been initiated when the Fast MACD (blue) line crossed above its Slow Signal (red) line with a stop placed below the September 2015 lows in case the price did not follow-through and move higher.

Bullish Divergence:

Conversely, the pattern between SPX and its MACD during this same timeframe displays confirmation. That is, as SPX and its MACD formed lows in late August 2015 both made higher lows at the end of September 2015. Such confirmation has positive implications for future price action and can be referred to as bullish confirmation. As the name implies, MACD is merely confirming the price trend in SPX and should add confidence in holding any existing position or, in this case, identifying a reliable trade set up. A long position could have been opened after the Fast MACD (blue) line crossed over the Slow Signal (red) line. As always, a protective stop would need to be place below the most recent price low.

Bullish Confirmation:

Charts are in arithmetic scale

In the charts above, MACD is calculated in the conventional manner as follows: 
1)      Calculate the 12-day Exponential Moving Average (EMA) of prices.
2)      Calculate the 26-day EMA of prices.
3)      Subtract the 26-day EMA from the 12-day EMA and plot the differences as a blue line. This is the Fast MACD line.
4)      Calculate the 9-day EMA of the fast line and plot the result as a red line. This is the Slow Signal line.
Source: Alexander Elder’s “New Trading for a Living”

As always, please feel free to contact me with any questions or comments. Thanks for reading. 
JD
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