Moving Average Convergence Divergence – Is it Important?
On the topic of MACD, I decided to reduce the amount of noise on the topic to the essential need to know information. I encourage you if you have a day to spare to do further reading on the topic, however it can be a little hard going and is good if you suffer insomnia.
MACD is an important indicator.
MACD was developed by Gerald Appel as a means of easily showing the Moving Averages of a stock in a way that could show the strength of the difference of the Moving Averages.
For example if the 10 & 20 day moving averages for a stock move away from each other as the stock is going up, this means the stock is gaining strength.
MACD is based on 3 configurable parameters
Short = the shorter Moving Average e.g 10
Long = the longer moving average e.g. 20 or 30 etc
Period = the Moving average of the difference of the Short and Long above.
Use short MACD configuration for shorter term trading 5-35-5, or longer configurations for longer term trading 12-26-9 is popular, also 10-30-5.
Experiment, and also view charts on different timeframes to test if the indicator is true from different angles.
This could go on and on, however I will suggest now we move to a more practical use of MACD viewing it in real life on a real stock.
Please beware, sometimes MACD does not tell you anything about a stock, but in many cases it does. As always, if the indicators tell you nothing there is probably nothing to be told move on and look for other stocks.
Take a look at the Netflix (NFLX) Learning Chart below. Here we have a MACD configured of 10, 30, 5 Simple, and this is a 2 Day (per bar) Chart (Click to enlarge)
- Price Growing: Stock price is in growth mode almost doubling in the first quarter 2008.
- Negative Divergence: The trick with MACD is to look at the trend it is a powerful indicator when you compare the direction of the MACD Mountains with the Price Movement.
Point 2 illustrates, that although the price doubled in 2008 we saw the MACD make lower lows “negative divergence”. We see here a change in the MACD from positive to negative and the large mountain (below the Zero Line) forms. MACD is an oscillating indicator and as such is always tied to the Zero line in the middle.
- Price declining: here we see a strong decline in price for the rest of 2008 until November. Using a trend line to show this helps us visualize the direction easier.
- Positive Divergence: At the same time the price is declining we actually see a longer term Positive Divergence occurring from June to December. This essentially means that the “Gas in the tank of the sellers is slowly reducing”
However we should not have waited until December to buy the stock that would have been way too late. Instead we would look to Point 5.
- Buy Signal: MACD broke through the line of resistance: here we see the MACD breaking strongly past its previous high. I plotted a Trend Line in Orange to show this clearly.
If you had used MACD as your BUY SIGNAL, you would have netted 56% in 4 months.
Please do not think I searched though hundreds of charts to find a good example to demonstrate here. I did not; this was a stock in my watch list, and indeed bought based on this lesson. As you can see the dates are up to end of January 2009.
So what did we learn?
1. MACD is an oscillating indicator
2. It’s real strength lies in its ability to Diverge with price, showing that the trend may be changing or “How much fuel in the tank”
3. Use short MACD configuration for shorter term trading 5-35-5, or longer configurations for longer term trading 12-26-9 is popular, also 10-30-5. Experiment, and also view charts on different timeframes to test if the indicator is true from different angles.
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