See trend outlines with MACD

The moving average convergence divergence (MACD) is a technical indicator used in investment. It is one of the most common tools that investors and traders use to try to spot trend changes, which can help guide smart trading choices.

The MACD measures a stock’s momentum and can help investors spot shifts in that momentum that may indicate price turning points.

Understanding the MACD

Changes in price trends are almost always preceded by changes in momentum, which is the rate at which stock prices rise or fall. Changes in momentum can be easily detected with the MACD indicator.

The MACD was developed by Gerald Appel, whose purpose 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. To optimize these signals, 12- and 26-day moving averages for long-term signals and seven- and 18-day moving averages for short-term signals are ideal.

Use MACD channels

It is common to draw trend lines on a stock chart to discover patterns in how that security’s price rises or falls. You can also draw trend lines on the indicators, such as the two-line MACD. Drawing support and resistance levels creates a channel of action that provides a clearer picture of the trend’s momentum.

If the two moving averages diverge, momentum increases, and if they converge, momentum weakens. The distance between the two is drawn 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 bottom and determine the return line by connecting the tops of the MACD.

MACD and divergence

In November 2008 and then in February 2009, the MACD made lower highs while the stock price made equal highs; this is called divergence and tells investors that the stock is losing momentum. Investors can choose short positions when the MACD line bounces back from resistance. The short position can be covered when the MACD line reaches support at the bottom of the channel or for long-term trades when the channel is broken as it was near the end of April 2009.

If we looked at Figure 3 in July 2008, we might 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 made a major higher low, showing a build-up in bullish momentum.

In January 2009, the stock made a brand new high when it broke long-term resistance. However, the MACD showed momentum not confirming the breakout. The MACD continued to fall 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 will not sustain its current price level and that investors should sell their shares.

The 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 of the channel’s lines. Learning to implement and recognize these signals helps investors increase their profits when trading short and intermediate term trends.