Technical analysis indicators condense price information, providing analytical insight and trading signals which may not be obvious on a stock’s price chart. The Moving-Average-Convergence-Divergence (MACD) indicator fluctuates above and below zero, highlighting both the momentum and trend direction of a stock. Utilizing the MACD effectively requires understanding how it works, its functions and applications, as well as its limitations.
What is the MACD Indicator?
Gerald Appel developed the MACD in the 1970s, and it is one of the most popular indicators in use today. Traders use the MACD for determining trend direction, momentum and potential reversals. It is used to confirm trades based on other strategies, but it also provides its own trade signals.
Figure 1 shows the MACD applied to a daily chart of Apple (AAPL) stock.
Two lines compose the MACD: the MACD line and Signal line. These lines move together, except the MACD moves faster as the Signal line is a moving average of the MACD line.
The MACD Histogram that oscillates above and below zero shows the extent to which the MACD line is above or below signal line. The histogram provides a short-term view on recent momentum and direction. When the histogram is above zero, recent movement has been higher; below zero and the recent momentum was down. The greater the histogram value the greater the momentum of the recent move.
The Histogram is not always shown as part of the MACD indicator as many traders prefer to focus on the how the two lines (MACD and Signal) are interacting. These two lines are the source of most MACD strategies and price analysis.
The MACD is calculated as follows:
MACD Line = 12day EMA – 26day EMA
Signal Line = 9day EMA of MACD Line
EMA stands for exponential moving average.
The MACD Histogram is the MACD Line – Signal Line
Trading with the MACD Indicator
There are three primary uses for the MACD indicator, each offering advantages and disadvantages. Combing all three functions will help eliminate some losing MACD trade signals, as will using the MACD in conjunction with other indicators and price analysis.
Moves across the zero line on the indicator represent times when the 12day EMA is crossing the 26day EMA. When the MACD crosses the zero line from below, a new uptrend may be emerging. When the MACD crosses the zero line from above a new downtrend may be emerging.
Figure 2 shows several zero line crossovers in International Business Machines (IBM).
The strategy is to buy when the MACD crosses above the zero line, and sell (or take short positions) when the MACD line (black) crosses below the zero line. During choppy conditions this results in losing trades, and is profitable when strong trends emerge.
Hold long trades until the MACD crosses back below the zero line. Hold short trades until the MACD crosses above the zero line. This strategy is very basic and doesn’t have a stop loss, which means risk is not controlled. To utilize this strategy, traders need to implement their own form of risk control (see next section)
Zero line crossovers also confirm trends. When the MACD line is above zero it helps confirm uptrends and other strategies that indicate taking long positions. Below zero, the MACD confirms downtrends and taking short trades based on other strategies.
Signal Line Crossovers
Signal line crossovers provide better timing, and are preferred by most traders to zero-line crossovers.
With this method, a buy signal occurs when the MACD line crosses above the Signal line.
A sell (short) signal occurs when the MACD line crosses below the Signal line. Figure 3 shows IBM again, this time using Signal line crossovers. The buy and sell signals occur earlier in the price move than zero-line crossovers, potentially providing better entry and exit prices.
Since the MACD is an indicator, and not a trading system, there is no stop loss. For buy signals a stop can be placed below a recent low, and for short signals a stop can be placed above the recent high.
There are no built in targets, so trades are held until a crossover in the opposite direction occurs. New trades can then be initiated in the new crossover direction.
The downfall of this strategy is that it can result in “whipsaw” trades, when the MACD and Signal lines cross back and forth in a short amount time.
One way to avoid some whipsaws is to only take trades in the direction of the long-term trend. If the trend is up, only take a buy signals, and exit when the MACD line crosses back below the Signal Line.
Bearish divergence is when the price is making new highs, but the MACD isn’t. It shows that momentum has slowed, and a reversal could be forthcoming.
Bullish divergence is when the price is making new lows, but the MACD isn’t. It shows selling pressure has slowed, and a reversal higher could be around the corner.
Until divergence is confirmed by an actual turnaround in price, don’t base trades simply on divergence. A stock can continue to rise (fall) for a long time even while bearish (bullish) divergence is occurring.