Moving Average Convergence/Divergence (MACD) is one of the most common tools used by traders to determine the direction and momentum of a given stock. The standard MACD formula involves subtracting a stock's 26-day exponential moving average (EMA) from its 12-day EMA to create a single line that fluxuates above and below zero. The theory is that the movements of this line can be used to make accurate predictions. This article will take a look at what exactly the MACD is and how you can use it to profit!
What is the MACD?
The theory behind the MACD is an extension of the theory behind moving average crossovers. That is: If a faster moving average crosses over or under a slowing moving average, then the likelihood of a change in that direction is increased. Similarly, if the difference (or distance) between the two moving averages increases, then there is greater momentum in the prevailing direction. Combined, these are the two main strategies that traders use to predict direction and momentum.
Here's an example:
MACD Trading Strategies
Many traders consider the so-called "divergence strategy" to be the most reliable and profitable signals. Divergence occurs when the stock price trends in the opposite direction of the MACD oscillator. Typically, this signals that there will be a large future movement in the direction that the MACD is headed and opposite the direction that the stock is headed. The theory behind the strategy is that the momentum is building up in the stock and overdue to be released in a sudden burst as it hits a bottom.
The other two key signals that traders use are the "zero-line crossover" and the "moving average crossover" (mentioned above). The zero-line crossover strategy indicates that traders' should buy when the MACD oscillator crosses above the zero-line and sell when it drops below the zero-line. Meanwhile, the moving average crossover strategy indicates that traders' should buy when the faster EMA crosses above the slow EMA and sell when it crosses below the slow EMA. These strategies aren't considered as reliable as the divergence strategy and should only be used as confirmations for other signals in most cases.
Finally, traders often try to predict the tops and bottoms from a momentum standpoint by drawing trendlines on the MACD oscillator itself. Prior highs can often indicate just how excited investors are over a recurring even, such as an earnings surprise. The same goes with prior lows predicting just how far investors will sell down a stock under normal circumstances.
Conclusions
The MACD indicator is one of the most common tools used by traders to determine price direction and momentum. It is most useful as a confirmation indicator, but the divergence strategy is also used as a primary strategy for many. Overall, this is a useful addition to every traders' toolbox!
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