MACD

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You can make money as a swing trader by going contrary to the weekly and daily MACD signals.

But not for long.

I generally place MACD on almost every chart I discuss in this newsletter. It is important for the technical analyst to derive multiple confirming messages for optimal trading. This approach involves synthesizing such tools as trendlines, support and resistance, price patterns, moving averages, candlesticks and indicators such as RSI, Stochastics and MACD to see if they confirm or contradict one another. If, however, I had to choose only one indicator, my desert island favorite, it would be MACD.

Gerald Appel created Moving Average Convergence Divergence (MACD). In today's issue I want to discuss the construction of MACD and its buy and sell signals.

The swing trader can best use indicators for decision making when he or she has a clear understanding of their underlying design and assumptions. (I like to refer to this understanding process as "going inside the black box" -- hence the title of this newsletter section.) Those who fail to do this often end up applying the indicators mechanically, which usually leads to costly swing trading errors. In this issue I'm going to discuss MACD construction and the synthesis of weekly and daily MACD trading signals. In the next two newsletters I will discuss MACD divergence, the MACD histogram, and how you can use these tools to supplement your basic MACD analysis.

Below you'll find a weekly S&P 500 chart on which I've placed three moving averages: the 40-week, 12-week and 26-week. All of these are exponential moving averages (E.M.A.) -- a calculation method that weights recent price activity more heavily than distant data. (An E.M.A. is in contrast to the simple moving average, or S.M.A., which weights all prices equally).

The 40-week moving average was chosen as a long-term descriptor of trend. The chart shows a long decline, with the S&P below a downward sloping 40-week moving average, a bear market "signature."

As noted above, MACD is an abbreviation for "Moving Average Convergence Divergence." The MA part of the name stands for "moving average." Moving averages are trend following tools that have the power to keep the swing trader on the right side of the trade.

The CD stands for "convergence" and "divergence," or the phenomenon of the moving averages coming together and spreading apart. During a period of strong trend, the two MACD lines will grow further apart (divergence). During sideways consolidation, they will converge or come closer together, often crisscrossing one another several times. MACD is both a trend following tool and a momentum indicator that shows acceleration and deceleration of a trend.

The MACD line itself is constructed from two moving averages -- a 12-period, or faster, moving average and a 26-period, or slower moving average. The computer subtracts the 26-period moving average from the 12-period and creates a single line. I call this the "main line." The next calculation performed is the computing of a nine-period E.M.A. of the main line. This line is called the "trigger line," and it is from the interaction of these two lines that certain types of trading signals are generated.

Note the scale on the left-hand side of MACD. On this scale is a "0" line. The zero line is crossed bullishly when the faster 12-period underlying moving average crosses over the slower 26-period moving average.

In using MACD, you should always take great care to synthesize the weekly and daily indicators. I have seen little information on how to do that in books or on the web. As such, here are my conclusions on that important topic...

Weekly MACD should be looked to as describing the trend of the stock from a "trading perspective." When a stock or index is below a downward sloping 40-week moving average, then for the vast majority of time, MACD will be on a sell signal. During periods of countertrend rally, however, there are times when the weekly MACD will issue a buy signal. Even though the primary trend is down, these opportunities should be traded from the long side. (The opposite of these principles is true when a stock or index is above an upward sloping 40-week moving average.)

Daily MACD should be used as the catalyst to enter and exit positions. When weekly MACD is on a sell signal, then fresh sell signals in daily MACD should cause the swing trader to take a short position (assuming other technical indicators on the chart such as trendlines and candlesticks support the trade, of course).

Since MACD is a trend following indicator, it will do a very good job of keeping you in the trade for almost the entire period in which it is profitable. When the daily MACD gives a buy signal, then short positions should be covered. You can then reinitiate a short position on the next MACD sell signal.

One limitation of MACD is that it works very poorly during periods of price consolidation. When MACD begins to generate numerous trading signals back and forth in a short period of time, its buy and sell advice should be ignored.

Below you'll find a one-year daily chart for the S&P 500. As we have seen, this particular weekly chart has given only three trading signals -- two sells and one buy. The daily chart, when used in conjunction with the weekly, gives a total of 12 signals in the year. I describe each of these below.

1. Sell short at point #1, as both the weekly and daily MACD give a sell signal.
2. Cover your short. Do not go long, as weekly MACD is on a sell.
3. Initiate a new short position.
4. Cover your short. This is a nice rally, but weekly MACD remains on a sell. During this period, swing traders might search for strong stocks whose weekly and daily MACD charts give a buy signal.
5. Initiate a new short position.
6. Cover your shorts. Take long positions here, as both the weekly and daily MACD are now giving buy signals.
7. Avoid using MACD as a trading signal because of the whipsaws.
8. The MACD lines now begin to diverge. Take the sell signal.
9. Cover shorts.
10. Initiate a new short position.
11. Cover shorts.
12. MACD has almost rolled over and given a fresh sell signal, but not quite.

By effectively using MACD to your advantage, you can develop a profitable trading system. And when you combine MACD with several other technical analysis tools, the results can be even more profitable.