The MACD is a trend following
momentum indicator that shows the relationship between three moving averages
of prices.
This method can be used for any time frame. It could be 5 minute bars, 15
minutes bars or daily bars. Many traders will also trade in multiple time
frames using a longer time frame for trend, and the shorter period for entry
and exit.
The MACD is the difference between a 26-period and 12-period exponential
moving average. A 9 period exponential moving average, called the “signal”
(or “trigger”) line is plotted on top of the MACD to show buy/sell
opportunities. On the charts below, the MACD line is the green colored
line, and the trailing, slower moving line is the signal line. Some
technical analysis programs will show the MACD as a histogram bar.
There are three popular ways to use the MACD: crossovers,
overbought/oversold conditions, and divergences.
The most common use is as a crossover method. Using this interpretation,
the trading rule is to sell when the MACD falls below its signal line.
Similarly, a buy signal occurs when the MACD rises above its signal line. It
is also popular to buy/sell when the MACD goes above/below zero.
Some traders will use MACD as an overbought and oversold indicator. When
using the indicator in this manner, when the shorter moving average pulls
away dramatically from the longer moving average (i.e., the MACD rises), it
is likely that the security price is overextending and will soon return to
more realistic levels. MACD overbought and oversold conditions vary from
security to security.
The other way some traders use MACD is to spot divergences from an
anticipated movement. Since there are no indicators or patterns that work
all the time, reactions against the anticipated move can signal a major
move. A bearish divergence occurs when the MACD is making new lows while
prices fail to reach new lows. A bullish divergence occurs when the MACD is
making new highs while prices fail to reach new highs. Both of these
divergences are most significant when they occur at relatively
overbought/oversold levels.
I will also use MACD combined with the breaking of support. Support can be
defined differently depending on the strategy. I like using the lowest low
and highest high of the last 20 bars depending on my time frame.
Let’s look at Worldcom Corp. (NASDAQ: WCOM).
After dropping from 31 to 20 in a move during the first 3 weeks of October,
WCOM has rallied to 27 on Friday.
This move from 21 to 27 may be just a retracement in a long downtrend.
Notice how the MACD is turning and flashed a Sell signal late Friday.
If WCOM opens unchanged or down, I would exit any longs in WCOM.
An aggressive trader would re-establish a Short position here as the major
trend is still down.
Notice how this resistance area corresponded with a previous resistance on
October 10.
Many stocks have similar patterns. On 60 minute bars, the market looks much
better than on daily bars.
Know your time frame and manage risk accordingly.
