If there were ever a quest in the world of investing on par with the search for the Holy Grail, it would be acquiring the ability to spot trend changes. There are many ways investors attempt to do this with varying degrees of success, but a common trend-tracking tool is the two-line moving average convergence divergence (MACD). This tool measures a stock's momentum and can aid investors in spotting changes in market sentiment.
Just like stock prices, momentum will trend. Momentum changes precede stock price changes. This article is designed to help you spot trend changes in momentum and stock price.
Nature of Momentum
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. These momentum changes can be easily observed using the MACD (mack-dee) indicator.
Moving Average Convergence Divergence (MACD)
Gerald Appel developed the MACD indicator in an attempt to chart momentum by measuring the increasing and decreasing space between two exponential moving averages (usually the 12-day and the 26-day). If the distance between the two moving averages is diverging, then momentum is increasing, whereas if the moving averages are converging, then momentum is decreasing. The distance between the two moving averages is graphed in what is called a MACD line (black), as seen in Figure 1.
Figure 1: Two-line MACD
To confirm changes in momentum, a nine-day exponential moving average is added as a signal line (the red line in Figure 1). A buy signal occurs when the MACD line crosses above the signal line. The sell signal occurs when the MACD line falls below the signal line. In an attempt to optimize these signals, it was found that 12- and 26-day moving averages for long-term signals and seven and 18-day moving averages for short-term signals were ideal.
Channeling the MACD
The practice of drawing trendlines on a stock chart is as almost as old as buying stock itself, but what you may not know is that you can also draw trendlines on the indicators, such as the two-line MACD. Drawing a support and a resistance level at the same time creates a channel of action that helps measure the trend's current strength.
In Figure 2, we measured the stock's trend strength by creating a channel. To create the channel, draw support by connecting the bottoms and determine the return line by connecting the tops of the MACD.
In November 2008 and then in February 2009, the MACD created lower highs while the stock price created equal highs; this is called divergence and tells investors that the stock is losing momentum. Investors could choose short positions when the MACD line bounces down off resistance. The short position may be covered when the MACD line reaches support at the channel's bottom or for long-term trades when the channel is broken like it was near the end of April 2009.
Figure 2: Bearish divergence and trend
If we had looked at Figure 3 in July 2008, we may have noticed that the MACD was making higher lows and diverging from the stock price. This phenomenon is signaling a possible reversal. In November, the reversal was confirmed when the MACD created a major higher low, demonstrating a buildup in bullish momentum.
January 2009 saw the stock make a brand-new high when it broke long-term resistance; however, the MACD showed that momentum wasn't confirming the breakout. The MACD kept falling as the stock attempted to establish support near the $80 level. When the stock broke support, the MACD broke its support line, confirming that the stock would not maintain its current price level and investors should sell their shares.
Figure 3: Bullish divergence and trend
The strength of the current trend can be measured by channeling the MACD. Spot trend reversals by looking for divergences in momentum as measured by the MACD channel. Determine the buy and sell signals using the MACD crossovers or bounces off the channel's lines. Learning to implement and recognize these signals helps investors increase their profits when trading short and intermediate-term trends.