As part 2 of our series on #TechnicalAnalysis, today we discuss one of the most useful and popular technical indicators for #commodity and coffee trading: the Moving Average Convergence Divergence (MACD).
In this article, we will discuss how this indicator is constructed, how we can trade with it and what the limitations are, all while using examples from our favorite coffee futures "C" market (KC).
If you are interested in learning more about technical analysis, this indicator (along with many others) are taught in detail as part Day 3 of the Coffee Trader's Course.
It is also part of the suite of indicators that we use to predict the daily close with our Coffee Valuation Score. I contend that the MACD can be an effective early warning indicator of price shifts ... but only to a point. We have to understand its limitations.
Let’s start at the beginning: What is the MACD and how is it constructed?
The MACD is a trend-following technical study that measures Market Momentum and can generate buy and sell signals. The acronym MACD stands for Moving Average Convergence Divergence and the name does a pretty good job of explaining how it is constructed.
It is calculated by subtracting a “slow” 26-period exponential moving average (EMA) from a “fast” 12-period EMA. Hence the MACD represents the “convergence” or “divergence” between these two exponential moving averages.
MACD = 12 day EMA - 26 day EMA
There is a 3rd component that is paired with the MACD as well and that is a 9 period EMA of the MACD line itself called the “signal line”. So when we look at the MACD on chart, we are really looking at the MACD line vs its own 9 period EMA.
This tool helps hedgers and speculators understand whether the bullish or bearish movement in prices is strengthening or weakening.
However, don’t stress too much about the calculation as the math is typically generated for you automatically by software.
How to use the MACD?
On your screen, you will see the MACD along with the 9-day EMA signal line. They both oscillate between positive and negative values.
Trader’s receive a buying signal when the indicator crosses above the signal line and a sell signal when it crosses below. This is referred to as a “MACD crossover”.
Let’s look at a practical example in coffee using the KCK22 chart to drive home the concept. The grey line represents the MACD, while the purple line represents the signal line.
In the green circles, shows where the MACD crosses above the signal line giving a buy signal, suggesting that the price was likely to experience an upward momentum. The green arrows show where the price was when the buy signal was given. The red circles and arrows show the sell signals.
You can see the profit areas of each signal in the red and green rectangles.
Personally, I find this indicator easier to read with a histogram. It’s displayed in the picture above, and represents the distance between the MACD and the signal line.
When the MACD is above the signal line, the histogram will be above the baseline (upward and blue). When the MACD is below the signal line, the histogram will be below the baseline (inverted and red).
The histogram can be used as a tool to identify when bullish or bearish momentum is high.
The zero line in the histogram occur represents when the MACD crosses the signal line, indicating a bullish or bearish signal.
However, there is another benefit to using the histogram as well. We can analyze its peaks and troughs. These indicate the rate of change of the underlying momentum itself and provide even more insight into potential momentum shifts. See example below.
Finally, much like the RSI, the MACD histogram lets us compare confirmation and divergence with price trends. Confirmation is when the MACD histogram is making new highs or lows along with price, and divergence is when the Histogram is failing to make new highs or lows with price. This can provide an early signal a shift that momentum is changing.
Limitations of the MACD
Much like other technical indicators, it’s important not to overestimate the MACD’s ability to provide accurate predictions on price trends. When any one indicator is shown to be effective, the market has a way of quickly arbitraging out the profit so you won't find a "holy grail."
Rather than using the MACD as a stand-alone trading system, the indicator is best used as an objective way of measuring momentum. This is especially effective when paired with fundamental analysis.
For example, if your fundamental analysis says that coffee is overvalued, but the price is still pushing higher, a sell signal from this indicator can provide an early warning that technical buying is waning.
Alternatively, if the market is cheap with no known reason to be bullish, a buy signal can indicate that the momentum is shifting and traders should start looking to see if there is a fundamental reason for a rally.
Even with the benefit that this indicator can provide, we should be aware of the two main ways the MACD can steer us wrong:
First, the MACD can signal possible reversals that don’t actually happen.
Second, the MACD can fail to forecast a reversals.
Failure to forecast a reversal can especially happen with very rapid fundamental changes. As this indicator measures momentum, and if momentum changes rapidly it may not detect it. Even still, markets often anticipate even rapid fundamental changes. The July 2021 frost for example was actually caught by this indicator.
However, after the frost (n the example above), notice how despite the MACD doesn’t cross below the signal line before a huge drop. We did see that the histogram peak was indicating that the bullish momentum was losing strength though (divergence). There was also a “Three Black Crows” candlestick pattern, indicating a reversal to the downside.
This demonstrates how you can use complementary tools to analyze charts, and how one aspect of one indicator on its own can’t always provide perfect signals about market momentum.
It's important to close with warnings about these tools, and that is why we try to show how and when this tool can fail you. However, knowing the limitations of the tool doesn’t take away from its utility. Used correctly, along with a suite of tools and a solid understanding of the fundamentals, the MACD can provide a great early indication on trend shifting and help you to trade well in the coffee market.
If there are any other indicators you would like to see us discuss, please let us now!