MACD Histogram Helps Determine Trend Changes

Charting is an invaluable tool that helps traders profit from momentum. Here we look at the moving average convergence divergence (MACD) histogram, a measurement of the difference between the fast MACD line and the signal line.

The MACD is a momentum indicator that can be used to anticipate changes in market sentiment. However, it is not foolproof: experienced traders look to other metrics, such as trading volume, for a more complete perspective on market sentiment.

Understanding the MACD Histogram

A MACD chart consists of three elements: the MACD line, a signal line, and a histogram, charted around a horizontal axis known as the baseline. The MACD chart is usually graphed just below the security's price chart, so that price movements can be compared with changes in the MACD chart.

The MACD line is calculated by subtracting a long-term exponential moving average (EMA) from a shorter-term exponential moving average. Generally, these are the twelve-day and 26-day EMA, calculated based on each day's closing price.

The signal line is calculated by taking the difference between the two EMAs, and from that number create a nine-day moving average. It is not necessary to calculate these values yourself, and sophisticated charting software makes life easy with its back-testing capabilities that automatically prepare all the calculations instantly for the user.

Finally, the histogram is determined by subtracting the signal line from the MACD line. This is easier to interpret than looking at the two lines alone, since it is sometimes difficult to tell if one curve is steeper than the other. The histogram is positive when MACD is higher than its nine-day EMA, and negative when it is lower.

How to Read the MACD Histogram

Traders use the MACD histogram to identify potential trend reversals and price swings. When the histogram is positive (i.e., above the baseline) that means that the MACD is higher than its nine-day average, signifying a recent increase in upward momentum. When the histogram is below the baseline, the MACD is lower than its nine-day average.

Zeroes in the MACD histogram occur when the MACD line crosses higher than the signal line (generally considered a buy signal) or below the signal line (a sell signal). Peaks and troughs in the histogram indicate when a burst of bearish or bullish momentum is losing strength, and the curve is likely to return to its mean.

However, chart analysis isn't as simple as looking for crossovers on a graph. Skilled technical analysts look at a range of other metrics, such as volume and the relative strength indicator, when producing a price forecast.

Example of MACD Histogram

The following chart demonstrates one potential way to read the MACD histogram. The top curve represents the price chart for a hypothetical security, along with a set of trendlines. The middle chart is a MACD line and histogram, centered around a baseline. The lower histogram represents the volume for each trading period.

In this example, there are two very clear "sell" signals. The first is at around the $55 level, when the MACD line fell beneath the signal line. The stock price then dropped dramatically to about the $35 level in a matter of a few trading days, when another sell signal triggered a new series of down days. Prices fell to the mid-teens over a period of about two months.

Since then, you could see that the company traded in a somewhat narrow range (sideways movement) and the two EMAs that made up the MACD were hugging the signal line. This is a "wait-and-see" pattern. During this period, volume trended downwards during this period of sideways trading, indicating a lack of market interest.

The Bottom Line

This example should demonstrate how observing the MACD histogram can help anticipate changes in trends in both short-term and long-term price momentum. It is important for traders to learn to recognize these trends and not bet against them. Fighting a trend is a sure way to get pummeled.