- MACD is a technical indicator that can generate buy-and-sell signals.
- It is particularly useful in non-trending markets.
- In addition to other analysis, MACD can help you navigate big price swings.
Before global markets hit the brakes in late January and early February, falling to prices not seen since July 2017, stocks were trending consistently up. Since then, markets have recovered most of the decline, retracing those losses back near all-time highs.
If stocks continue to trade in a range, rather than continuously setting fresh highs, active investors with short-term time frames may want to consider using MACD, in addition to other fundamental and technical methods, to get a handle on this market. MACD had suggested the possibility of the market being overvalued before the selloff, and active investors may be able to use some potential MACD signals that are currently developing to trade the market.
How MACD works
The Moving Average Convergence-Divergence indicator, commonly known as MACD, is a technical indicator consisting of 2 lines—the MACD line and the signal line—as well as a bar chart. It is used to generate buy-and-sell signals, and to determine whether an investment or index may be overbought (i.e., potentially expensive) or oversold (i.e., potentially cheap).
MACD can be approximated by subtracting the value of a longer exponential moving average (EMA) from a shorter one. The shorter EMA is constantly converging toward, and diverging away from, the longer EMA. This causes MACD to oscillate around the zero level.1 A signal line is created with an EMA of the MACD line. See the chart below for a sense of what MACD looks like.
MACD is a momentum oscillator that is generally best employed in non-trending markets—where prices fluctuate in a range. That's why MACD may be more useful now, compared to a couple of months ago, given that the market's uptrend was interrupted by a pullback and it has retraced prior prices.
Short-term buy-and-sell signals are generated by the MACD line and the signal line. These 2 lines fluctuate around the zero line, which is found on the y axis on the right side of the chart. The zero line is also significant because it can act as support and resistance.
Additionally, oscillators like MACD are generally most valuable when their value reaches extremes of its boundaries (i.e., the MACD and signal lines are far away from the zero line). Consequently, when the MACD line is well below the zero line in extremely negative territory, it can suggest an investment may be oversold (i.e., a buy signal). Alternatively, when MACD is well above the zero line in extremely positive territory, it can suggest an investment may be overbought (i.e., a sell signal). From mid-January until the pullback, both the MACD and signal line had moved deeper into positive territory (a sell signal) on the S&P 500. Currently, the MACD line and signal line are both near zero, suggesting neither a buy nor sell sign based on this signal.
In regards to the zero line, a sell signal is given when the signal line or the MACD line crosses below the zero line, and a buy signal is given when they cross above the zero line. The MACD line and signal line recently crossed above the zero line (a buy signal), although both remain close to the zero line.
The difference line, represented in the chart above by the blue bars, is typically presented as a bar chart around the zero line. This bar chart represents the difference between the MACD line and the signal line, and is designed to help depict when a crossover may take place. Recall that a crossover generates buy and sell signals. A narrowing of the difference line (i.e., when the bars decrease) illustrates the potential for a crossover. As the chart above shows, the MACD bars on the S&P 500 narrowed when market volatility picked up in late January. More recently, the bars have narrowed again, suggesting an impending crossover may be possible.
These signal line crossovers, as opposed to zero line crossovers, are typically the more frequent action many traders look for when using MACD. A buy signal is generated when the MACD line crosses above the signal line, and a sell signal is generated when the MACD line crosses below the signal line. As the chart above illustrates, a sell crossover signal occurred just before the late January/early February correction. The next possible signal line crossover would be a sell sign (the MACD line crossing below the signal line).
Confirming the trend
One technique that technical analysts may use to confirm the direction of the trend is to determine whether the MACD indicator is making higher highs or lower lows in conjunction with the price. Many traders wait for a "trigger," or some sort of confirmation of the divergence. One MACD signal to keep an eye on over the short term is if both MACD lines continue to mirror the market rebound. If they do not rise as well, that would be a sign of market weakness, according to this indicator.
Of course, you should never use a technical indicator in isolation. Instead, it can be one of many tools you use to evaluate the market or an investment opportunity. With the market potentially back in a trading range, indicators like MACD may be particularly helpful for short-term investors.
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