Things are looking spooky in the Middle East.

At 12:30 on Thursday, the S&P began a sustained 107-point dive straight through to the close on fears that Iran would attack Israel.

Between Russia and Ukraine, China and Taiwan, and Israel and Hamas (which means Israel and Iran), there’s plenty of geopolitical tension to spook markets into a more sustained pullback, no matter how strong the job market remains.

However, whether stocks go up or down doesn’t matter to us. We’re traders, not cheerleaders.

When the markets turn, we respond. Every day, we wake up, take the market’s temperature, and decide what kind of market climate we’re in.

We’ve had a strong momentum year and a steady uptrend. But these things reverse, and we must stay alert to shifting sentiment.

With shifting trends and momentum in mind, I want to get you up to speed on the MACD indicator.

It’s a dual-purpose utility knife that, while not great range-bound markets, helps you nail trend reversals and gauge momentum.

What Makes MACD Tick?

The Moving Average Convergence Divergence (MACD) is a powerhouse among technical indicators. Developed in the late 1970s by Gerald Appel, MACD revolutionized traders’ analysis of markets.

After watching the indicator at work for a while, it’s hard not to feel the rhythm of the markets as it seamlessly blends momentum and trend-following into a single, powerful indicator.

At its core, the MACD utilizes exponential moving averages (EMAs) to gauge the momentum of a financial instrument.

EMAs differ from simple moving averages (SMAs) by the weighting each assigns to the data points it calculates.

An SMA effectively weights each data point (trade price, in this case) equally; the first day’s price has the same weight as the last day’s price in the calculation period.

Add the closing prices over the periods to get the SMA and divide by the number of periods. The result is a smooth line that follows the price action, helping to identify the trend direction by cutting out the noise.

EMAs apply more weight to the most recent prices. Essentially, newer prices contain more relevant information.

This sensitivity to newer information means the EMA reacts more quickly to price changes than the SMA.

The EMA formula generally involves a multiplier and starts with the SMA as its basis. However, each subsequent price point is weighted exponentially over time, allowing for a more nuanced representation of recent market movements. The emphasis on recent data makes the EMA particularly useful for traders looking for signals of short-term trend changes or wanting to gauge the momentum of a price move.

MACD uses three EMAs: the 9-day, 12-day, and 26-day EMAs. If you are looking at weekly data, then rather than a 9-day EMA, the MACD would use weekly EMA, for instance.

It also has three parts: 1) the MACD line, 2) the MACD signal line, and 3) the MACD histogram.

The arrows indicate the parts indicated in the StocksToTrade chart below.

The difference between 12 and 26-day EMAs forms the MACD line (in blue).

The MACD signal line (in yellow) is a 9-day EMA of the MACD line itself (yes, it’s an EMA of the difference between the two EMAs). It serves as a trigger for buy and sell signals.

The signal line is the trend reversal portion of the MACD indicator.

When the MACD line crosses above the signal line, it’s a buy signal. Conversely, a cross below forms a sell signal. This dance between the lines is more than just movement; it’s a narrative of market sentiment shifting in real-time.

Finally, the MACD histogram (red and green at the bottom) plots the difference between the MACD line and its signal line, providing insight into momentum.

Widening histograms suggest increasing momentum, while narrowing ones hint at a slowdown, potentially signaling reversals before they’re evident in the price itself.

This dual-purpose nature, both trend-following and momentum signals, gives MACD its power.

This dual functionality means it tracks not just where the market is going but also how fast it’s getting there, giving traders a more nuanced view of market dynamics.

However, like any technical indicator, the MACD is not infallible. It excels in trending markets but can lead to false signals in range-bound conditions where prices fluctuate within a tight range. The key to leveraging the MACD lies in understanding its strengths and limitations. You should combine it with other indicators and analysis to confirm signals.

With the basics in hand, I show you the MACD in action in the video below.

Check it out. And make sure to reference this StocksToTrade Ultimate Resource Guide for other technical indicators to add to your trading arsenal.

 

Until next time,

Tim Bohen

Lead Trainer, StocksToTrade

 

*Past performance does not indicate future results