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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