June 2007
Study Tip: MACD Fundamental Behavior
by Howard Arrington
To understand a study more thoroughly, it needs to be observed on a
theoretical Elliott wave formation. To often a study is slapped on a
chart, adjustable parameters are tweaked, and with the benefit of hindsight some
trade signals are derived. The advanced student might go the extra mile
and delve into the mathematics of the study's formula. But the fundamental
behavior of the study is not understood well. This article will help you
understand the Moving Average Convergence Divergence (MACD) Oscillator better through an original approach. The basic concepts of the Elliott Wave Theory are that action is followed by
reaction, and there are 5 waves in the main trend, followed by 3 waves in the
correction. Since this pattern is seen over and over in the
markets, a theoretical chart based on these principles will be used so MACD
can be analyzed without market 'noise' obscuring its fundamental
behavior. The MACD is the spread between a short period average and a long
period average. Typical parameters for the two averages are 5 and 34,
which will be used in the examples for this article. 
Various
characteristics can be found in the 5/34 MACD study applied to this theoretical
chart. 1) Divergence is not present as the price action
puts in any of the swing tops or swing bottoms. Other studies,
however, such as Stochastic and R.S.I.
often show divergence. 2) The patterns formed by waves 1, 3
and 5 are very similar. So traders really need to count waves and wait for
the completion of the 5th wave to have the ideal entry signal. 3)
The pattern at the Ideal Sell is a lower right side shoulder on both the price
action and on the MACD study. The pattern at the Ideal Buy is a
raised right side shoulder on the chart and on the study. 4)
If you want an earlier signal you might plot a Moving Average of the MACD such
as is illustrated by the Red study line. The signal would be the MACD
crossing its average. In the example, a 9 period average is plotted as the
Red line. Again, wait for the crossing after the 5th wave is in
place. 5) The a-b-c correction in the retracement waves 2
and 4 will cause the MACD to cross its average and cross below the zero
line. Both of these would be false signals. Wait for the
completion of the 5th wave. Average Formula: Now that the fundamental behavior of
MACD is understood as the Elliott
waves develop in a market, the theoretical chart will be used to observe the
effect of different average formulas. The first
decision is whether to use Simple, Exponential, Weighted or Howard's averages in the
MACD calculations. All examples shown in the next graph use
the same 5 and 34 parameters for the two averages. 
The
only significant difference observed here is that Divergence is present when the
Howard's moving average formula is used. Note in the plot for the Howard's
formula that the hills for the 3rd wave and the 5th wave are decreasing in their
amplitude. Click here to learn more about Howard's
formula. Average Parameters: Now the
parameter for the 1st average will be varied to see the effect it makes in the
MACD plot. 
The
observable difference is that a higher parameter results in a shallower
valley. The pattern remains basically the same. Now the 2nd
average's parameter will be varied. 
There
is a bit of Divergence in the 3rd and 5th wave patterns when a smaller parameter
is used for the 2nd average. The patterns and signal interpretations
are basically the same, regardless of the parameter used for the 2nd average. The
theoretical chart has been very helpful in gaining a better understanding the
fundamental behavior of the MACD study. Click the links below to
read other articles where the theoretical wave has been used to discover the
fundamental behavior of other studies.
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