Learning to trade in the direction of short-term momentum can be a difficult task at the best of times, but it is exponentially more difficult when one is unaware of the appropriate tools that can help. This article will focus on the most popular indicator used in technical analysis, the moving average convergence divergence (MACD). Gerald Appel developed this indicator in the 1960s, and although its name sounds very complicated, it's really quite simple to use. Read on to learn how you can start looking for ways to incorporate this powerful tool into your trading strategy.
The popularity of the MACD is largely due to its ability to help quickly spot increasing short-term momentum. However, before we jump into the inner workings of the MACD, it is important to completely understand the relationship between a short-term and long-term moving average.
As you can see from the chart below, many traders will watch for a short-term moving average (blue line) to cross above a longer-term moving average (red line) and use this to signal increasing upward momentum. This bullish crossover suggests that the price has recently been rising at a faster rate than it has in the past, so it is a common technical buy sign. Conversely, a short-term moving average crossing below a longer-term average is used to illustrate that the asset's price has been moving downward at a faster rate, and that it may be a good time to sell.
Notice how the moving averages diverge away from each other in Figure 1 as the strength of the momentum increases. The MACD was designed to profit from this divergence by analyzing the difference between the two exponential moving averages. Specifically, the value for the long-term moving average is subtracted from the short-term average, and the result is plotted onto a chart. The periods used to calculate the MACD can be easily customized to fit any strategy, but traders will commonly rely on the default settings of 12- and 26-day periods.
A positive MACD value, created when the short-term average is above the longer-term average, is used to signal increasing upward momentum. This value can also be used to suggest that traders may want to refrain from taking short positions until a signal suggests it is appropriate. On the other hand, falling negative MACD values suggest that the downtrend is getting stronger, and that it may not be the best time to buy.
It has become standard to plot a separate moving average alongside the MACD, which is used to create a clear signal of shifting momentum. A signal line, also known as the trigger line, is created by taking a nine-period moving average of the MACD. This is found plotted alongside the indicator on the chart. As you can see in Figure 2, transaction signals are generated when the MACD line (the solid line) crosses through the signal line (nine-period exponential moving average (EMA) - dotted blue line).
The basic bullish signal (buy sign) occurs when the MACD line (the solid line) crosses above the signal line (the dotted line), and the basic bearish signal (sell sign) is generated when the MACD crosses below the signal line. Traders who attempt to profit from bullish MACD crosses that occur when the indicator is below zero should be aware that they are attempting to profit from a change in momentum direction, while the moving averages are still suggesting that the security could experience a short-term sell-off. This bullish crossover can often correctly predict the reversal in the trend as shown in Figure 2, but it is often considered riskier than if the MACD were above zero.
Another common signal that many traders watch for occurs when the indicator travels in the opposite direction of the asset, known as divergence. This concept takes further study and is often used by experienced traders.
As mentioned earlier, the MACD indicator is calculated by taking the difference between a short-term moving average (12-day EMA) and a longer-term moving average (26-day EMA). Given this construction, the value of the MACD indicator must be equal to zero each time the two moving averages cross over each other. As you can see in Figure 3, a cross through the zero line is a very simple method that can be used to identify the direction of the trend and the key points when momentum is building.
In the previous examples, the various signals generated by this indicator are easily interpreted and can be quickly incorporated into any short-term trading strategy. At the most basic level, the MACD indicator is a very useful tool that can help traders ensure that short-term direction is working in their favor.
The biggest disadvantage of using this indicator to generate transaction signals is that a trader can get whipsawed in and out of a position several times before being able to capture a strong change in momentum. As you can see in the chart, the lagging aspect of this indicator can generate several transaction signals during a prolonged move, and this may cause the trader to realize several unimpressive gains or even small losses during the rally.
Traders should be aware that the whipsaw effect can be severe in both trending and range-bound markets, because relatively small movements can cause the indicator to change directions quickly. The large number of false signals can result in a trader taking many losses. When commissions are factored into the equation, this strategy can become very expensive.
Another MACD drawback is its inability to make comparisons between different securities. Because the MACD is the dollar value between the two moving averages, the reading for differently priced stocks provides little insight when comparing a number of assets to each other. In an attempt to fix this problem, many technical analysts will use the percentage price oscillator, which is calculated in a similar fashion as the MACD, but analyzes the percentage difference between the moving averages rather than the dollar amount.
The MACD indicator is the most popular tool in technical analysis, because it gives traders the ability to quickly and easily identify the short-term trend direction. The clear transaction signals help minimize the subjectivity involved in trading, and the crosses over the signal line make it easy for traders to ensure that they are trading in the direction of momentum. Very few indicators in technical analysis have proved to be more reliable than the MACD, and this relatively simple indicator can quickly be incorporated into any short-term trading strategy.