With stocks appearing to have slowed somewhat in early August 2014, after setting fresh all-time highs during July, could the market be entering a trading range? If so, the Moving Average Convergence-Divergence indicator, commonly known as MACD, may help you trade the market and decide if stocks might go higher, or if the risk of a sustained correction is mounting.
How the MACD indicator works
MACD is a technical indicator that is used to generate buy-and-sell signals, and to determine whether a security or index may be overbought (potentially expensive) or oversold (potentially cheap). It is a momentum oscillator that is generally most useful in non-trending markets—where prices fluctuate in a range.
Buy-and-sell signals are generated by two lines: the MACD line and the signal line (see the chart below for a sense of what MACD looks like). These two lines fluctuate around the zero line which is found on the y axis on the right side of the chart. The zero line is significant because it can act as support and resistance.
The difference line, shown in the chart above in green, 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. 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.
Oscillators like MACD are generally most valuable when their value reaches the extremes of its boundaries (i.e., the MACD and signal lines are far away from the zero line). Consequently, when MACD is well below the zero line in extremely negative territory—as it was near the bottom of the financial crisis—it can suggest that the market may be oversold. Alternatively, when MACD is well above the zero line in extremely positive territory—as it was in early 2008—it can suggest that the market may be overbought.
What could MACD be suggesting about the S&P 500 now?
Using a year-to-date chart as of August 18, 2014, the MACD line and signal line both made a negative cross below the zero line in early August—which was a bearish sell signal. 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. More recently, the MACD line and signal line made a positive cross above the zero line—a bullish buy signal.
The MACD line is now positive territory, however, it is nowhere near an extreme positive reading, relative to both recent and longer-term lows. A buy signal would be generated by either the MACD or signal line being well below the zero line. Conversely, a sell signal would be generated by either the MACD or signal line being well above the zero line.
Signal line crossovers, as opposed to zero line crossovers, are typically the more frequent action traders look for when using the 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. The last crossover signal was when the MACD line crossed above the signal line in mid-August 2014. This was a buy sign.
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. This is something to look for in the coming days and weeks.