Spotting Trend Reversals With MACD

Spotting Trend Reversals With MACD
If there were ever a quest in the world of investing on par with the search for the Holy Grail, it
would be acquiring the ability to spot trend changes. There are many ways investors attempt to
do this with varying degrees of success, but a common trend-tracking tool is the two-line moving
average convergence divergence (MACD). This tool measures a stock's momentum and can aid
investors in spotting changes in market sentiment.
Just like stock prices, momentum will trend. Momentum changes precede stock price changes.
This article is designed to help you spot trend changes in momentum and stock price.
Nature of Momentum
Momentum in charting is similar to momentum in physics; if you throw a ball in the air, it will
ascend at a slower and slower pace the higher it projects. After monitoring the changing
momentum, a person can determine when the ball will stop climbing, change direction and
descend.
Just like in physics, momentum changes occur before the price of a stock changes. These
momentum changes can be easily observed using the MACD (mack-dee) indicator. (Buy high and
sell higher. Find out if you could surf these risky waters, see Riding The Momentum Investing
Wave.)
Moving Average Convergence Divergence (MACD)

Gerald Appel developed the MACD indicator in an attempt to chart momentum by measuring the
increasing and decreasing space between two exponential moving averages (usually the 12-day
and the 26-day). If the distance between the two moving averages is diverging, then momentum
is increasing, whereas if the moving averages are converging, then momentum is decreasing.
The distance between the two moving averages is graphed in what is called a MACD line (black),
as seen in Figure 1.
To confirm changes in momentum, a nine-day exponential moving average is added as a signal

line (the red line in Figure 1). A buy signal occurs when the MACD line crosses above the signal
line. The sell signal occurs when the MACD line falls below the signal line. In an attempt to
optimize these signals, it was found that 12- and 26-day moving averages for long-term signals
and seven and 18-day moving averages for short-term signals were ideal. (For background on
this technical indicator, check out A Primer On The MACD.)
Channeling the MACD

The practice of drawing trendlines on a stock chart is as almost as old as buying stock itself, but
what you may not know is that you can also draw trendlines on the indicators, such as the two-
line MACD. Drawing a support and a resistance level at the same time creates a channel of
action that helps measure the trend's current strength.
In Figure 2, we measured the stock's trend strength by creating a channel. To create the channel,
draw support by connecting the bottoms and determine the return line by connecting the tops of
the MACD.
In November 2008 and then in February 2009, the MACD created lower highs while the stock
price created equal highs; this is called divergence and tells investors that the stock is losing
momentum. Investors could choose short positions when the MACD line bounces down off
resistance. The short position may be covered when the MACD line reaches support at the
channel's bottom or for long-term trades when the channel is broken, like it was near the end of
April 2009. (For related reading, see Divergences, Momentum And Rate Of Change.)
If we had looked at Figure 3 in July 2008, we may have noticed that the MACD was making
higher lows and diverging from the stock price. This phenomenon is signaling a possible reversal.
In November, the reversal was confirmed when the MACD created a major higher low,
demonstrating a buildup in bullish momentum.
January 2009 saw the stock make a brand-new high when it broke long-term resistance;
however, the MACD showed that momentum wasn't confirming the breakout. The MACD kept
falling as the stock attempted to establish support near the $80 level. When the stock broke
support, the MACD broke its support line, confirming that the stock would not maintain its current
price level and investors should sell their shares. (Learn to smooth trends and make confirming
momentum easier to identify; read Confirm Forex Momentum With Heikin Ashi.)
Figure 3: Bullish divergence and trend
Source: ProphetCharts
The Bottom Line
The strength of the current trend can be measured by channeling the MACD. Spot trend reversals
by looking for divergences in momentum as measured by the MACD channel. Determine buy and
sell signals using the MACD crossovers or bounces off the channel's lines. Learning to implement
and recognize these signals helps investors increase their profits when trading short and
intermediate-term trends. (To hear about the case against the MACD, read Candle Sheds More
Light Than The MACD.)

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Spotting Trend Reversals With MACD

Moving Average Convergence Divergence (MACD)

To confirm changes in momentum, a nine-day exponential moving average is added as a signal

Channeling the MACD

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