The MACD – What it is and how I use it for swing trading

The MACD is the MACDADDY.

Moving Average Convergence/Divergence (MACD) It is one of the primary indicators I use for swing trading.  In the past…before I grit my teeth to research what it was all about…I never really touched it because it just seemed to have too much going on.  The blue bars, the multiple lines moving up and down, crossing over each other like spaghetti…  What a mess!

It’s worth understanding though, and is one of the most popular indicators out there.  And for good reason!  I find that it really works for swing trading positive reversals.  After all, I like to know whether I am stepping in front of a moving train, or is the train slowing down to a perfect crawl, allowing me to jump on it and ride it back up for some profits!

I’m going to break down the MACD so it is super easy to understand the underlying logic behind it and how to use it for swing trading.

First a quick primer on MACD:

  • It was invented by Gerald Appel in the late 1970’s.  It is meant to show changes in momentum, direction and duration of a trend.  It classified as a trend indicator.
  • It is an oscillator: which is an indicator that moves up and down over a central line within a band.  Oscillators are helpful in understanding overbought or oversold conditions
  • There are several ways to interpret MACD, which can make it extremely useful to determine if your potential swing trade is worth taking.  It is also helpful in telling you that your existing swing trade is weakening and whether it is time to take your profits.

Ok, let me break down the trusty MACD for you.

Moving Averages…The Exponential Moving Average

The MACD is based upon moving averages, which are simply calculations to show the average price over a certain time range.  I’m sure you are quite familiar with them.  This indicator uses several Exponential Moving Averages (EMA).  Just to make sure you and I are on the same page here…an EMA gives more weight to the most recent data.  For example a simple 30 day moving average, treats all 30 days/periods equally.  That means that the prices on the 30th day in the past, has the same value in the calculation as 1 day ago.  What makes and EMA different, is it gives more weight to the most recent prices, rather than treating all prices equally.

The reason is because by their nature, moving averages are lagging indicators.  They are a reference point, giving you an idea of the average price after all.  It is like steering a big ship.  The bigger the ship (a longer moving average), the slower it takes to turn.

Since they are lagging, the Exponential Moving Average (which is still lagging), tries to alleviate this to some extent by giving more importance to the recent prices than those earlier in the time series.  This way, it clings, closer to the current price.  It hugs the price a little better.  It reacts more quickly than its plain ol’ vanilla cousin, the moving average.  So the 10 day EMA moves more quickly than the 10 day MA.  The 30 day EMA moves more quickly than the 30 day MA…etc.

Back to the ship analogy:

  • Lets think of the regular moving average (MA) as a ship having the standard rudder in the back, making it slower to turn.
  • Let’s think of the Exponential Moving Average (EMA) as having a rudder in the back of the ship and one in the front of the ship, allowing it to turn more quickly than it’s slower cousin.  It is still slow to turn, and doesn’t turn on a dime, but it can turn faster, since it is giving more importance to more recent data (aka…the front rudder).

Ok, let’s me start breaking this all down with some charts.  For this post, I’m going to use the chart of Apple (AAPL), in honor of Gerald Appel… since he’s such a beast.  🙂

Here’s the first chart:

 

On this chart of AAPL, I’ve added the 12 day EMA and the 26 day EMA to the chart.  Since the MACD uses the 12 and 26 day EMA, this is going to help you see how those moving averages on the chart above display themselves on the MACD ribbon below the chart.  You can look at the MACD indicator on its own and get a better feel of what is really happening on the chart above.

Notice how the 12 day EMA reacts quicker than the slower period 26 day EMA.  You will also notice that the 12 day EMA crosses back and forth over the slower 26 day EMA.  Like a speedboat crossing back and forth in front of a slower moving tanker freight-liner ship.  Those crossover’s are significant.  They are showing you that the more recent prices are (12 days) are above or below the longer term average (26 days).

The crossovers are then giving you a signal that there is a change in the direction of the stock and a signal of where it might continue to trend.

Let’s look at the same chart, with some additional info:

This one is a doozy.  Take some time to really understand and get a feel for what is going on here.  To make this a bit less cluttered, I took out those blue bars (the histogram) within the MACD ribbon.  You can still see some choppy remnants of what I cut out, but who cares?  Right now, I want to remove the clutter so you can focus on the main concept of the MACD indicator.

Notice what is happening here.  Where the 12 day EMA crosses back and forth over the 26 day EMA, on the chart above, look at the ribbon below… that is EXACTLY where the MACD LINE crosses over the BLUE “zero” line on the oscillator.

Basically, what the MACD line on the indicator ribbon below is doing, is showing you THREE THINGS:

  1. When the 12 day crosses the 26 day, the MACD line is exactly at the Zero line.  That is exactly where they intersect.
  2. When the 12 day is ABOVE the 26 day on the chart, the MACD line is ABOVE the zero line
  3. When the 12 day is BELOW the 26 day on the chart, the MACD line is BELOW the zero line.

Isn’t that a thing of beauty?  The MACD line is showing you the interactions between the faster 12 day with the slower 26 day EMA, all with that one line.  The logic then, is if the 12 day crosses over the 26 day, that is telling you that the more recent prices are moving in the opposite direction of the longer period prices.  The trend is headed in the direction of the 12 day period…get it?  That is why you have buy and sell signals when that crossover happens.  All the MACD is doing is showing you what is happening to the 12 and 26 day EMA.  You don’t need to have those two moving averages cluttering up your chart.  The indicator is representing the interactions of those two moving averages with one simple line.  It shows you where those two moving averages are, and how they relate to each other by how that MACD line interacts with the Zero line on the oscillator!

Take a look at the signals if gives.  When the 12 day crosses and heads below the 26 day from above, the oscillator crosses the zero line and gives a sell signal.  When the 12 day EMA crosses above the 26 day  EMA from below, the oscillator crosses zero line from below and heads into positive territory, giving you a buy signal.

This is one way to use the MACD oscillator: Buying and selling when the MACD signal line crosses the zero line.

Now let’s continue to build on this and add more to it.

Take a look at this next chart:


This is a close-up of the MACD ribbon.  Just as before, we have our familiar ribbon, but now you can see that I have the RED line that I had cut out earlier, along with the blue histogram bars.  Now we are going to focus on the interactions between the BLACK MACD line and the RED MACD line.  The BLACK line is called the MACD line (remember, it’s just a net of the 12 and 26 day EMA) and the RED bar is called the 9 bar EMA of the MACD signal line.

This is important: The RED line is the 9 day/period Enhanced Moving Average (EMA) of the BLACK MACD signal line.  

Think about this…therefor it is an average of an average!  It is slower, showing the overall trend of the BLACK MACD line.

So the RED line is slower.  It is an average of the BLACK line.  Again, using our boat analogy, the BLACK MACD line is moving more quickly, turning back and forth, while the RED line is slower to move, showing more of the overall trend.  So when you see the black line moving across the red line, it is showing that there will be a change in direction of the trend.  So lets say the prices are moving higher.  Eventually, as the black line continue to stay above the red line, the new, higher prices will start to pull that line up as well.  It can only go on for so long though, prices don’t move straight up forever.  When the momentum starts to slow, the lines will become closer together, and eventually the trend will change and the black line will cross over the red line.

Then let’s focus on the BLUE histogram bars.  All they are showing you is the difference between the BLACK and RED lines.  The bars are above the ZERO line when the BLACK line is above the RED line, and they are below the zero line when the BLACK line is below the RED line.  The blue bars, just subtract the difference between the two.  It makes it easier to see the difference between the two lines.  It also is amazing how you can see that there are “hills” that have a certain rhythm.  You can almost see where the trend is heading.  That’s the point.  It is much easier to see that “hey, it looks like we are heading in this direction now”.  Again, the MACD is a trend indicator.  It is visually showing you the trend and where it is heading and how strong it is.

 

Here is the same MACD ribbon at the bottom of the AAPL chart.  Here you can see I used the crossovers SIGNAL line, back and forth across the RED EMA line as buy and sell signals.  I use this method the most.  With my swing trades, I am buying positive reversals.  On this chart on AAPL, I only traded the very last BUY signal on the right.  I didn’t trade the others.  The simple reason is that with my trading method, I don’t follow specific stocks and trade them.  I trade-off of the results on my screens.  AAPL showed up on my screen and I followed it for 1 day (sometimes it could be a few days), and then I pounced when the time was right.

With all of my swing trades, I am buy a stock when the MACD looks as it does on the right, with a deep swing below the zero line of both the red and black lines.

Here is a closeup of my entry:

The BLUE histogram bars form that deep reverse hill.  I buy when that signal line is crossed.  Sometimes I even buy before the line is crossed, because you can sometimes clearly see that it is inevitable that the line will be crossed…the hill is moving back up to the zero line.

I will point out that I never just trade-off of just the MACD…I have multiple conditions that have to be met before I enter a swing trade…but this is ALWAYS how the MACD looks when I am entering a trade.

Let’s compare the two major methods used when trading off of the MACD, which are:

  • SLOWER METHOD: Buying or selling when the BLACK MACD line crosses above or below the ZERO line.
  • FASTER METHOD: Buying or selling when the BLACK MACD line crosses above or below the RED 9 period EMA line

Here is the chart of AAPL, with the comparison results of trading the same moves with both methods:

Look at how the signals that occur when using each method produce different results.

When the price move of a security like APPL made are as drastic as this…moving from in a range from about 179 to about 154, in such a short period of time, it is very apparent how using the two different methods produce drastically different results!

On the MACD ribbon line, the time that has elapsed does not seem to be that great (and it isn’t), but in that relatively short period of time, the price moves of APPL were huge!  Notice the difference on the two sell signal prices.  That is a 4% difference.  You would have lost 4%, just by waiting for the slower signal when the MACD line crossed the zero center line.

Same thing with the buy signals:  That’s an over a 5% difference!  You would have lost the opportunity to gain 5%, if you would have waited for the MACD line to cross the zero line.

That is why on swings that I trade (where the price moves are deep and the BLUE histogram forms that heavy, underneath hill), I normally take the trade that occurs when the MACD line crosses the red line.

There are disadvantages to trading the faster method though.  If you go back and look at one of the earlier charts I listed above, you can see that there were times that you would have been whipsawed in and out of AAPL if you traded off of the faster crossover signals.  You might have made a little bit of a profit, but maybe if your account is smaller, the gains might not be enough to offset your transaction costs.

Summary: Swing Trading using the MACD

I hope that my explanation breaking down the basics of the MACD indicator were helpful to you.  When swing trading, I never leave home without it!  Like any indicator, it is important not to put all of your faith behind it though.  I have found that with swing trading, you cannot extract just one thing and focus on it exclusively.  Any indicator cannot be used in a vacuum.  It is just one piece of the puzzle, that when fit together with other pieces provides a weight of evidence that are then used to determine whether to enter a swing trade or not.  It is one of the few indicators that I consistently use, and for good reason…it works!

Let’s stay in touch!  If you haven’t signed up for my mailing list, you can do that below.

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Good luck with your trading!

Glenn

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