Moving Average Convergence Divergence (MACD)

The moving average convergence divergence or MACD as it is popularly called is the relationship between 2 exponential moving averages. It is best used as a trend and momentum. However it is not useful to identify consolidation patterns. It is often used with a 9 day exponential moving average which acts as a signal line.

MACD divergence

If the MACD is making new highs but the price is not, divergence has occurred. This is a bullish divergence. However if the MACD is making new lows without the price following suit, a bearish divergence has occurred. These divergences are significant when MACD is overbought or oversold.

When divergence occurs, there is a possibility of a trend reversal.

How can option traders make use of MACD?

Bearish Signal

Source: Yahoo Finance

In the image shown here, 9 is used for fast period, 15 is used for the slow period and 9 is used for the signal period.

If the MACD falls below the signal line, it signals that a security has just turned bearish. At this point as MACD crosses below the signal line, it may be time to initiate a bearish options strategy such as a bear put spreads, bear call spreads or even buying put options outright.

If the MACD rises above the signal line, it means that the security has just turned bullish. Option traders can use bullish option strategies at this point.

Some option traders make sure  that these crossovers of MACD above or below the signal line are confirmed before making their trades.

If there is a steep gradient(significant rise) in the MACD , it may mean that the security is overbought.  If there is a steep fall in the MACD, it may mean that the security is oversold.Overbought and oversold conditions mean that the price will return to more normalised levels.

For more accurate indications of whether a security is overbought or oversold, it is important to complement MACD indicators with the stochastics indicators.

Read next: Stochastics