Spotting Trend Reversals With MACD

The moving average convergence divergence (MACD) indicator is one of the most common tools investors and traders use to try to spot trend changes—the holy grail of the markets.

The MACD measures a stock's momentum and can aid investors in spotting shifts in that momentum that may betray price turning points.

The Nature of Momentum

Momentum in markets is similar to momentum in the physical world. If you throw a ball in the air, it will ascend at a slower and slower pace until it reverses course and begins falling. And the same is true in markets.

Changes in price trends are almost always preceded by changes in momentum, which can probably most easily be detected with the MACD indicator.

Understanding the MACD

The MACD was developed by Gerald Appel, whose goal was to chart momentum by measuring the relationship between two exponential moving averages (the default setting for the indicator is the 12-day and 26-day averages).

To confirm changes in momentum, a nine-day exponential moving average is added as a signal line (the red line in Figure 1). Roughly speaking, a buy signal occurs when the MACD line crosses above the signal line, and a 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 old as stock charts themselves. But what you may not know is that you can also draw trendlines on the indicators, such as the two-line MACD. Drawing support and resistance levels creates a channel of action that offers a clearer picture of the trend's momentum.

If the two moving averages are diverging, then momentum is increasing, and if they are converging, then momentum is weakening. The distance between the two is graphed in what is called a MACD line, as seen in black in Figure 1.

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.

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 called divergence, and is one of the strongest signals of 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. 

Bottom Line

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.