Level 2 Patterns & indicators · Part 7/9
MACD and Trend Strength
MACD combines two ideas from the previous articles: it is built from moving averages but behaves like an oscillator.
Construction
Three components:
- The MACD line is the difference between two exponential averages, conventionally 12 and 26 periods.
- The signal line is a 9-period EMA of the MACD line.
- The histogram is the difference between the two lines.
Because the line is a difference, it does not measure price level but the distance between the short and long averages – that is, the change in momentum. Rising means the trend is accelerating; falling while prices still rise means the move is slowing.
The three usual readings
- Signal line crossover. The fastest but least reliable signal – in sideways phases it flips constantly.
- Zero crossing. Equivalent to the two underlying averages crossing. Slower and steadier.
- Divergence with price. The same observation as with the RSI, with the same caveats.
The histogram turns before the lines and is therefore the fastest but noisiest part. Using it as a standalone signal essentially trades the second derivative of price – and that is barely distinguishable from zero inside the noise.
The scaling flaw
A practically important point missing from most descriptions: MACD is not normalised. Its value depends on the price level and volatility of the instrument. A MACD of 2.5 means something entirely different for a stock at 30 than for an index at 18,000.
It follows that MACD values are not comparable across instruments, and fixed thresholds are meaningless. Only the path within the same instrument is comparable.
ADX: strength without direction
The average directional index measures how strong a trend is – without saying which way it runs. Values below roughly 20 count as trendless, above 25 as trending; those boundaries are convention, not measurement.
Its use is as a filter. Almost every indicator works either in trends or in ranges, never both. A strength measure answers the prior question of which of the two states you are in – and therefore which tool applies at all.
The limitation is the same as everywhere: ADX rises after a trend has started. It confirms; it does not announce.
The real lesson of this chapter
Every indicator on this level – averages, RSI, MACD, ADX – is a function of the same price series. They add no information; they present existing information differently.
Two things follow. Five indicators in one chart do not increase certainty; they manufacture apparent confirmation from quantities that are highly correlated with each other. And no indicator can show something that is not already in the price series. The question is therefore never which indicator is right, but which property of the series you want to see.
How strongly different instruments and quantities actually move together is measurable – the correlation matrix does exactly that for markets.
Next
A measure with no direction at all that is nonetheless immediately useful: volatility.