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Friday, July 15, 2016

MACD (Moving Average Convergence Divergence) - A Powerful Technical Analysis Indicator

There are over 180 indicators available to the Technical Analyst all attempting to determine what the share price is likely to do next, with the MACD & Moving average the most widely used. It is a testament to the human mind that we can take 5 pieces of information, the open, high, low, close and volume information and create all these different indicators.

Indicators work like magnifying glasses allowing a trader to closely examine the information available to them. The indicator however tells the trader no more than what they can see in a candlestick or bar chart. It is based on the same information.

Powerful Technical Analysis Indicator

Moving Average Convergence Divergence (MACD) trails only the combination of price and volume in my hierarchy of trading tools and indicators.  It's THAT good.  But it has one major limitation in that it only considers price action, not volume.  Hence, it cannot be trusted as much as price/volume.  There are many reasons why the MACD works in gauging momentum, too much in fact to discuss in one blog article so I'll write about the MACD often.  But I would suggest that before you follow ANY indicator that you fully understand how and why that indicator works - and its limitations.  Buying or selling a stock simply because "this line crosses that line" is a recipe for disaster.  You're swimming in a sea of market maker-infested waters and your capital is the bait.  When I lose on a trade, I want to at least know that I had a plan to limit my risk and maximize my potential return.  If it results in a loss, then so be it.  Stock trading is a zero-sum game.  Someone is going to win and someone is going to lose.  Our goal should be two-fold:  (1) to win more than we lose and (2) to have higher percentage winners than losers.  If we can achieve both, we'll make money.  It sounds easy, but it takes a lot of knowledge, patience, discipline and experience.

The MACD is a powerful tool to help us achieve our goals.

Moving average convergence divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the "signal line", is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.

There are three (3) common methods used to interpret the MACD:

1. Crossovers - As shown in the chart above, when the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell. Conversely, when the MACD rises above the signal line, the indicator gives a bullish signal, which suggests that the price of the asset is likely to experience upward momentum. Many traders wait for a confirmed cross above the signal line before entering into a position to avoid getting getting "faked out" or entering into a position too early, as shown by the first arrow.

2. Divergence - When the security price diverges from the MACD. It signals the end of the current trend.

3. Dramatic rise - When the MACD rises dramatically - that is, the shorter moving average pulls away from the longer-term moving average - it is a signal that the security is overbought and will soon return to normal levels.

Traders also watch for a move above or below the zero line because this signals the position of the short-term average relative to the long-term average. When the MACD is above zero, the short-term average is above the long-term average, which signals upward momentum. The opposite is true when the MACD is below zero.



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