For many stock traders, four letters can spell the difference between a winning and losing position. MACD (moving average convergence divergence) ranks among the key stock market indicators (along with moving averages and RSI) that traders use consistently in their analysis.
Let’s discuss a number of creative ways to use this powerful and versatile gauge.
MACD, introduced in the late 1970s, is a trend-following momentum indicator. It helps to determine when a trend, and its associated momentum (i.e., directional speed and duration) has ended or begun, or might reverse direction.
Be aware that MACD is a “lagging” or “backward-looking” indicator, which means its signals are delayed, but don’t let that deter you. When MACD yields a signal, it is often significant, especially if used on a weekly chart (versus the daily chart favored by short-term traders). In fact, the longer the MACD time frame, the more valid the results, which is one reason longer-term traders like myself prefer to use a weekly chart.
When you view MACD on a chart, you see two lines. The black line is referred to as the “MACD line.” The gray (or red) line is referred to as the “signal line.” Remember: the MACD line is the leader line, while the signal line is the laggard line.
In addition, a horizontal line runs across the chart called the “zero line” (0 line). The main function of the zero line is to alert you to the primary trend of the underlying price action.
Four Simple Trading Signals
At its most basic level, MACD generates four signals:
Buy: When the MACD line crosses above the zero line, it’s bullish.
Buy: When the MACD line crosses above the nine-day signal line, it’s bullish.
Sell: When the MACD line crosses below the zero line, it’s bearish.
Sell: When the MACD line crosses below the nine-day signal line, it’s bearish.
Note: When both the MACD line and nine-day signal line move in the same direction (uptrend or downtrend), that is a stronger, more significant signal.
Keep in mind that just because MACD generates a buy or sell signal does not mean it is an actionable trade. Like that of any indicator, there are false signals. In addition, it’s essential that you confirm with other indicators before betting real money on a trade. Think of these MACD buy and sell signals as guidelines, not rules.
Another limitation of MACD is that it does not work as well at stock market tops or when market volatility is low. Therefore, if you use MACD on the Dow Jones Industrial Average or the S&P 500 in this current market, the signal is not as useful. That is why you should use MACD on individual stocks until volatility returns to the major market indexes.
What MACD says about Tesla
For example, the weekly stock chart of Tesla shows its MACD is above the zero line, and the MACD line is above the signal line. Tesla is also above its moving averages.
Based on this information, Tesla stock currently is a short-term “strong” buy. If Tesla’s MACD line drops below its signal line while both lines are above the zero line, the shares would be a “moderate” buy.
A few years ago, I spoke with MACD’s creator, Gerald Appel. He told me that he created MACD in the late 1970s by entering numbers into a punch machine and a spreadsheet. After the personal computer was invented, he was able to automate the process.
Appel expressed surprise that MACD became so popular. “It works because it’s adaptable to any time frame,” he said. “You can get a good reading of the major trend of the market by using MACD patterns that are based on monthly data. You can also use it on a five-minute chart.”
MACD gives the most precise signals at market bottoms. Said Appel: “It’s more accurate at market low points than high points because of the way the market behaves. Market bottoms tend to be very sharp and pronounced, while tops tend to be broad and slow. It’s also possible for the market averages to keep drifting upwards while more and more stocks are falling.”
Appel cautioned that you must confirm MACD signals against other indicators. “No indicator is infallible,” he said. “You might get a market rise and MACD turns down. Perhaps you think this is a sell signal. Well, it might not be.”
Appel added that he likes to work with different MACD time frames simultaneously. For example, if the short-term MACD turns up along with the intermediate MACD, he’s more confident that the signal is valid.
One of the most powerful (but often ignored) additions to the MACD is the MACD-Histogram. Developed by Thomas Aspray in 1986, this oscillator is used to gauge momentum. It is a separate program that should be available on your charting package. Traders who use this feature typically view both MACD and the histogram on a stock chart simultaneously.
The histogram is a series of bar graphs at the bottom of the stock screen. If the bars move above the zero line, it means the underlying stock (or index) is gaining strength, i.e., momentum. If the bars move below the zero line, the stock or index is losing strength.
Many beginning traders don’t realize that momentum always changes before price does. That is what makes MACD and the MACD-Histogram so valuable. Both indicators detect when momentum is weakening. It could also be a signal to become bullish if the histogram bars move above the zero line.
If the MACD-Histogram bar changes to a lighter color, it means that momentum is diminishing. It is not a sell signal; it simply means that enthusiasm for that particular stock is waning.
As mentioned earlier, if the histogram bar rises above the zero line, that is a buy signal. An uptrend may be developing. If the histogram bar drops below the zero line, that is a sell signal. A downtrend may be developing.
If you see the index prices as well as stock prices move higher, but MACD turns lower, that is a red flag. In addition, if you see the MACD-Histogram changing colors and the bars getting shorter, that confirms momentum is weakening (but confirm this against RSI or stochastics).
If you have never used MACD or MACD-Histogram, give it a try. Use these measures for any stock that has hit bottom and is on its way higher. They’ll help confirm whether the stock has legs or is a just giving traders a head fake.