One of the most commonly used tools in active trading is known as the moving average convergence divergence (MACD) indicator. Although the name of this indicator seems intimidating, it is actually quite simple to use and it can often generate profitable trading ideas.
As you can see from the chart below, the indicator consists of two parts: the MACD line and the signal line. The MACD line is simply the difference between two exponential moving averages, typically the 12-day and 26-day averages. The reason that traders pay attention to varying lengths of moving averages is because they want to figure out how the short-term momentum is changing relative to the longer-term momentum. If the short-term average falls faster than the long-term average, the MACD moves downward. Traders use this to suggests that the selling pressure is increasing.
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The signal line, shown as the dotted blue line on the chart, is also known as a trigger line and is created by taking a nine-period moving average of the MACD line. The signal line is plotted alongside the MACD line and is used to predict changes in a stock's direction.
The most common sell sign is triggered when the MACD line crosses below the signal line (illustrated by the right arrow in the chart above). A MACD cross below the signal line tends to predict that the bears are gaining control of the direction and it generally leads to a short-term move lower. Let's take a look at some stocks that have recently triggered a MACD sell sign:
Momentum in charting is similar to momentum in physics; if you throw a ball in the air, it will ascend at a slower and slower pace the higher it projects. After monitoring the changing momentum, a person can determine when the ball will stop climbing, change direction and descend. Just like in physics, momentum changes occur before the price of a stock changes. The bearish MACD crossovers that have occured on the charts of the stocks mentioned above suggests that the bears are taking control of the momentum and that the prices of the underlying shares could be poised for a short-term pullback. (For related reading, see Spotting Trend Reversals With MACD)
It is important to note that the short-term nature of the MACD indicator can often lead to being whipsawed in and out of a position several times before being able to capture a strong price movement. This tool should be used in conjunction with other technical indicators to ensure a more accurate idea about a stock's direction. (For more, see A Primer On The MACD) Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!