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 rises faster than the long-term average, the MACD moves upward. Traders use this to suggests that the buying pressure is increasing.
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 left 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 higher. Let's take a look at a stock that has recently triggered a MACD sell sign:
Philip Morris International Inc. (NYSE:PM) - Philip Morris, a recent spinoff of Altria Group (NYSE:MO), engages in the manufacture and sale of tobacco products outside of the United States. Since its spinoff, Philip Morris has been quite volatile, ranging from its spinoff price of around $49 up to a high of just under $55. The last time we saw Philip Morris in a bearish MACD crossover was back in May. Following the crossover, Philip Morris lost about $5 before finding a bottom. Since then, the stock has come up again, but found resistance at the influential level of about $54, set by the previous high. In the last month, the stock has come down again, leaving a double top in its wake, in addition to creating a bearish MACD crossover.
Going forward, traders should look for the bears to keep control of the price movement until the stock manages to break through the now stronger resistance set at around $54. In the short-term, we will continue to watch Philip Morris as it approaches the double bottom support that should exist around $49. If the bears manage to break through this support, the outlook may become worse for the price of this stock in the longer term.
It is important to note that the short-term nature of the MACD indicator can often cause it to be 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.