How to Use MACD as an Technical Indicator
MACD, or short for Moving Average Convergence/Divergence, is a very popular technical indicator used for both swing trading and long-term trading. It is one of the simpler tools using Moving Averages to analyze trend-following characteristics. It helps you determine a momentum by subtracting the longer moving average (usually 26 days) from the shorter moving average (usually 13 days). The resulting plot forms a line that oscillates above and below zero, without any upper or lower limits.
MACD’s credibility is noted not only by many technical analysts but also by major financial sites like Bloomberg. According to this article back in March 2009, Bloomberg mentioned that the MACD is indicating a further rally potential:
The Moving Average Convergence/Divergence chart, which is based on calculations from the benchmark’s closing average during the past 9, 12 and 26 days, has generated a “bullish divergence,” UBS analysts Michael Riesner and Marc Müller said.
The so-called MACD measure has posted seven “major divergences” since 1932, they said. In five occasions, stocks rallied into a bull market, as happened in 1932, 1935, 1942, 1982 and October 2002. In the other two cases, stocks advanced at least 15 weeks, the analysts wrote.
“With the current bullish divergence in the weekly MACD, we have a high-probability pattern for expecting a stronger and longer-lasting countertrend rally, if not even the start of a new bull market,” Riesner and Müller said in a note today.
Well look at where we are today. The market has continued its rally, gaining 34% since March 9th and still has not lost its momentum.
Another article details the study done by researchers around the reliability of different technical indicators:
Ever since the Standard & Poor’s 500 Index peaked in October 2007, six of eight strategies — which are supposed to make money whether stocks rise or fall — failed, according to back-testing data compiled by Bloomberg. As the bear market erased $11 trillion from the value of U.S. equities, buy and sell signals from those six technical indicators produced losses of as much as 49 percent, the data show.
Of the eight strategies, stochastics, Bollinger bands, relative strength, commodity channels, parabolic systems and the Williams %R indicator generated buy and sell signals that resulted in losses between the S&P 500’s peak of 1,565.15 on Oct. 9, 2007, and its March 9 trough, the data show. They did worse as the index then rallied 30 percent through last week.
The so-called DMI generated a gain of 24 percent. The moving average convergence/divergence indicator, which bases trades on the difference between 12- and 26-day moving averages, provided profits of $25,896 from a $100,000 investment.
What It Does
MACD measures the difference between two Exponential Moving Averages (EMAs). A positive MACD indicates that the 12-day EMA is trading above the 26-day EMA. On the other hand, a negative MACD indicates that the 12-day EMA is trading below the 26-day EMA. Basically, when the MACD is above the 0 line, it is indicating that the momentum is bullish. When the MACD is negative however, it is indicating that the momentum is bearish.
What to Look For
Many analysts use MACD to look for a positive or negative divergence (hence the Convergence/Divergence) that helps them gain an edge in future trend anticipation. As you can see in the chart below, sometimes the stock price is trending down even though the MACD is trending up. Look at the period between June and August.
What this indicates us is that the positive momentum is increasing, and thus the stock price is headed for a potential rally to “correct” the divergence.
Many technical analysis experts also look for “cross-overs” that help users determine a bullish or a bearish reversal potential.
As you can see above, when the 12 days moving average (bold black line) crosses the 26 day moving average (blue line), you should watch the next price movements very carefully as it tends to signal a trend reversal. If the 12 days MA crosses above the 26 days MA, it’s a bullish signal. On the flip side, if the 12 days MA crosses below the 26 das MA, it’s a bearish signal. You can see from the above chart how the stock price actually played out.
Just like any other technical analysis tools, there is no definitive guarantees to these indicators. You must use various data points to make your ultimate decision with the appropriate risk levels you are willing to accept. Good luck and happy trading.