How to Trade Using MACD

The MACD indicator is primarily used to trade trends and should not be used in a ranging market. Signals are taken when MACD crosses its signal line, calculated as a 9 day exponential moving average of MACD. The basic MACD trading rule is to sell when the MACD falls below its 9 day signal line and to buy when the MACD rises above the 9 day signal line. Apart from signal line crossovers, traders can look for centerline crossovers and divergences to generate signals.

Signal Line Crossovers

Signal line crossovers are the most common MACD signals. The signal line is a 9-day EMA of MACD. As a moving average of the indicator, it trails MACD and makes it easier to spot turns in MACD. A bullish crossover occurs when MACD turns up and crosses above the signal line. A bearish crossover occurs when MACDturns down and crosses below the signal line. Crossovers can last a few days or a few weeks, it all depends on the strength of the move.

Signal crossovers are quite common. As such, due diligence is required before relying on these signals.Signal line crossovers at positive or negative extremes should be viewed with caution.It takes a strong move in the underlying security to push momentum to an extreme. Even though the move may continue, momentum is likely to slow and this will usually produce a signal line crossover at the extremities. Volatility in the underlying security can also increase the number of crossovers.

Below Chart shows IBM with its 12-day EMA (green), 26-day EMA (red) and MACD (12,26,9) in the indicator window. There were eight signal line crossovers in six months: four up and four down. There were some good signals and some bad signals. The yellow area highlights a period when MACD surged above 2 to reach a positive extreme. There were two bearish signal line crossovers in April and May, but IBM continued trending higher. Even though upward momentum slowed after the surge, upward momentum was still stronger than downside momentum in April and May. The third bearish signal line crossover in May resulted in a good signal.

Centerline Crossovers

MACD oscillates above and below the zero line, which is also known as the centerline. Centerline crossovers are the next most common MACD signals. These crossovers signal that the 12-day EMA has crossed the 26-day EMA. The direction, of course, depends on direction of the moving average cross. A bullish centerline crossover occurs when MACD moves above the zero line to turn positive.This happens when the 12-day EMA of the underlying security moves above the 26-day EMA. A bearish centerline crossover occurs when MACD moves below the zero line to turn negative.This happens when the 12-day EMA moves below the 26-day EMA.

Centerline crossovers can last a few days or a few months. It all depends on the strength of the trend.MACD will remain positive as long as there is a sustained uptrend. MACD will remain negative when there is a sustained downtrend.Above Chart shows Pulte Homes (PHM) with at least four centerline crosses in nine months. The resulting signals worked well because strong trend emerged soon thereafter.

Below Chart shows 3M (MMM) with a bullish centerline crossover in late March 2009 and a bearish centerline crossover in early February 2010. This signal lasted 10 months. In other words, the 12-day EMA was above the 26-day EMA for 10 months. This was one strong trend.

DIVERGENCES

DIVERGENCES FORM WHEN MACD DIVERGES FROM THE PRICE ACTION OF THE UNDERLYING SECURITY. A BULLISH DIVERGENCE FORMS WHEN A SECURITY RECORDS A LOWER LOW AND MACD FORMS A HIGHER LOW. THE LOW LOWER IN THE SECURITY AFFIRMS THE CURRENT DOWNTREND, BUT THE HIGHER LOW IN MACD SHOWS LESS DOWNSIDE MOMENTUM. THE SLOWING OF THE DOWNTREND SOMETIMES FORESHADOWS A TREND REVERSAL OR A SIZABLE RALLY.

BELOW CHART SHOWS GOOGLE (GOOG) WITH A BULLISH DIVERGENCE IN OCTOBER-NOVEMBER 2008. THE MACD MOVING AVERAGES ARE BASED ON CLOSING PRICES AND WE SHOULD CONSIDER CLOSING PRICES IN THE SECURITY AS WELL. NOTICE THAT THERE WERE CLEAR REACTION LOWS IN OCTOBER AS GOOGLE BOUNCED FOR A FEW WEEKS AND MACD MOVED ABOVE ITS SIGNAL LINE.MOREOVER,MACDFORMED A HIGHER HIGH AS GOOGLE FORMED A LOWER LOW IN NOVEMBER. THIS BULLISH DIVERGENCE WAS CONFIRMED WITH A SIGNAL LINE CROSSOVER IN EARLY DECEMBER.

A BEARISH DIVERGENCE FORMS WHEN A SECURITY RECORDS A HIGHER HIGH AND MACD FORMS A LOWER HIGH. THE HIGHER HIGH IN THE SECURITY IS NORMAL FOR AN UPTREND, BUT THE LOWER HIGH IN MACD SHOWS LESS UPSIDE MOMENTUM. WANING UPWARD MOMENTUM CAN SOMETIMES FORESHADOW A TREND REVERSAL OR SIZABLE DECLINE.

BELOW CHART SHOWS GAMESTOP (GME) WITH A LARGE BEARISH DIVERGENCE FROM AUGUST TO OCTOBER. THE STOCK FORGED A HIGHER HIGH ABOVE 28, BUT MACD FELL SHORT OF ITS PRIOR HIGH AND FORMED A LOWER HIGH. THE SUBSEQUENT SIGNAL LINE CROSSOVER AND SUPPORT BREAK IN MACD WERE BEARISH. TURNING BACK TO THE GME PRICE CHART, NOTICE HOW BROKEN SUPPORT TURNED INTO RESISTANCE ON THE THROWBACK BOUNCE IN NOVEMBER (RED DOTTED LINE). THIS THROWBACK PROVIDED A SECOND CHANCE TO SELL OR SELL SHORT.

DIVERGENCES SHOULD BE TAKEN WITH CAUTION. BEARISH DIVERGENCES ARE COMMONPLACE IN A STRONG UPTREND, WHILE BULLISH DIVERGENCES OCCUR OFTEN IN A STRONG DOWNTREND. UPTRENDS OFTEN START WITH A STRONG ADVANCE THAT PRODUCES A SURGE IN UPSIDE MOMENTUM (MACD). EVEN THOUGH THE UPTREND CONTINUES, IT CONTINUES AT A SLOWER PACE THAT CAUSESMACD TO DECLINE FROM ITS HIGHS. THE OPPOSITE OCCURS AT THE BEGINNING OF A STRONG DOWNTREND.

CONCLUSIONS

MACD IS SPECIAL BECAUSE IT BRINGS TOGETHER MOMENTUM AND TREND IN ONE INDICATOR. THIS MEANSMACD WILL NEVER BE FAR REMOVED FROM THE ACTUAL PRICE MOVEMENTS OF THE UNDERLYING SECURITY. THIS UNIQUE BLEND OF TREND AND MOMENTUM CAN BE APPLIED TO DAILY, WEEKLY OR MONTHLY CHARTS. MACD IS NOT PARTICULARLY GOOD FOR IDENTIFYING OVERBOUGHT AND OVERSOLD LEVELS. EVEN THOUGH IT IS POSSIBLE TO IDENTIFY LEVELS THAT ARE HISTORICALLY OVERBOUGHT OR OVERSOLD, MACD DOES NOT HAVE ANY UPPER OR LOWER LIMITS TO BIND ITS MOVEMENT. MACD CAN CONTINUE TO OVEREXTEND BEYOND HISTORICAL EXTREMES DURING SHARP MOVES.