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Swing Trading with the MACD

Posted on May 3, 2009 by Adam

Out of all the indicators and oscillators available to swing traders these days, few are as widely accepted and revered as the marvelous MACD. The MACD, which stands for “Moving Average Convergance and Divergance,” is used to guage market posture. This indicator can help you determine whether or not a particular stock is overbought or oversold.

Since MACD is based on values of moving averages, it’s a good idea to first understand exactly what a moving average is. A moving average is the average price of a stock over any given period of time. That period of time can be anywhere from minutes to months. The most common moving averages are 30, 50 and 200 day.

For example, the value of a 50 day moving average is calculated by averaging the closing prices over the last 50 days. Each day that passes, a new day is included in the calculation, and the oldest day is removed. The value of the average moves with time, hence the name moving average.

Calculating the Value of the MACD

A MACD indicator is calculated by taking the difference between two moving averages. Say, for instance, that the average closing price over the last 30 days has been 15. On the other hand, the average price over the last 10 days has been 25.

The value of the MACD is the value of the shorter period moving average minus the value of the longer period moving average. In this case, the MACD vaue is 10, or 25 - 15.

MACD = MA( Short ) - MA( Long )

10 = 25 - 15

The MACD is centered at a value of zero, that is, when both moving averages have the same value. Its value will oscillate around the center-line over time, indicating whether or not the underlying stock is overbought or oversold.

Overbought and Oversold

When the MACD becomes very positive, it means that buyers are in control. They have increased the value of the stock so quickly, that the faster moving average has increased far above the slower one. It is in these cases that the MACD is considered to be overbought. The same is true for when the sellers are in control. In that case, the price of the stock goes down to where the MACD reaches extremely low values. This is known as oversold.

When the MACD reaches extreme values, it is considered overbought or oversold. This is what it will look like.

Notice that the MACD, like most indicators, does not spend much time in overbought or oversold territory. It generally fluctuates between much less extreme levels, but when it exceeds a previous high or low, the probabilities favor a reversal.

That’s not to say that overbought stocks can’t keep going higher and oversold stocks can’t keep going lower, but it becomes increasingly likely that the stock will reverse as investors either take profits in overbought stocks or recognize value in oversold ones.

As a swing trader, I like to think of the MACD readings in terms of upside and downside risk. When I buy an overbought stock, it may go higher, but the overbought reading is telling me that not much potential, or risk, exists to the upside. On the other hand, it also means that a lot of downside risk exists. I’d prefer not to touch it for this reason.

From this chart, we can see that this is a hot stock. It seems like nothing will keep it down. A closer look at the MACD (black line) reveals that the stock is EXTREMELY OVERBOUGHT - just look at the previous highs and lows to get an idea. They are barely visible on this plot. I wouldn't touch this stock with a 10 foot pole.

Swing Trading Buy and Sell Signals

MACD can be used for more than just gauging market posture. They can also be used for generating precise swing trafing buy and sell signals. Personally, I don’t use a MACD when deciding whether or not to trade stocks, but it is an important component in many trading systems.

First of all, I will have to introduce two new concepts: the trigger line, and the histogram. These will come in handy, I promise.

The trigger line is a moving average of the MACD values, plotted on the same graph as the MACD line. If you look at the chart above, the red line is the trigger line. The number of periods that the trigger line used (remember, it’s a moving average) is usually between the fast and short periods. Here’s an example of how a MACD indicator is denoted:

MACD( Fast Period, Slow Period, Trigger Period)

MACD(12, 26, 9)

A histogram is simply a bar graph of the difference between the MACD and the trigger line.

The histogram is shown in blue. The red line is the trigger line, and the black line is the value of the MACD.

There are several types of buy and sell signals based on these three values.

The first, and most signficant swing trading buy signal, is when the MACD shifts from negative to positive. When the MACD shifts from positive to negative, this would be a sell signal. This signal is often referred to as a MACD center-line crossover.

On the chart to the left, try and identify the cenrter-line crossovers (there are two).

The second important swing trading signal is a trigger-line crossover. This occurs when the MACD line crosses over the trigger line. When the MACD moves from below the trigger line to above it, it is a buy signal. When it moves from above to below, it is a sell signal. There are three trigger-line crossovers on the chart shown above. Can you identify them?

The final swing trading signal is known as a divergence. When it emerges as a buy signal, it is known as a bullish divergence and when it emerges as a sell signal is is a bearish divergence. A bullish divergence occurs when the price chart is making lower lows, but the MACD histogram is making higher lows. A bearish divergence occurs when the price chart is making higher highs, but the MACD histogram is making lower highs.

An example of a bullish divergance. (MACD and trigger line not shown)

On their own, each of these signals doesn’t mean a whole lot, but when you get a convergence of all three signals, it can be a pretty actionable event. The moves you can expect the stock to make based on these signals are short swings, which is why they are perfect indicators for a swing trading time frame.

Drawbacks of the MACD

Personally, I don’t make trade decisions based on a MACD. Their real value, in my opionion, rests on their ability to determine how overbought or oversold stocks are.

In my experience with using them for trade signals, I have been disappointed. They are based on past price action. They tend to go lower, after the stock goes lower, and higher, after the stock goes higher. I can tend to do a better job predicting future price swings (which I what I care about) using my own discretion.

A lot of swing trading systems rely on an indicator such as the MACD. Usually they use a combination of several different indicators. They would tell me that I’m using the wrong indicators or the wrong settings, but I would tend to shy away from those. I find that a lot of beginners get too tied up in indicators, and never really learn any trading discipline.

Relying on a black and white system will prevent you from building up a trading “spider sense,” which is what you ultimately want to have. If you like to use an indicator, why not go with the MACD, but don’t go overboard.

Until next time,

Happy Trading.

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My artistic rendering of a MACD (again)