Think about throwing a ball up in the air. As you throw that ball upwards, what is happening? The ball is fighting against the force of gravity and the resistance from the air as it climbs higher and higher. The fighting of gravity combined with the resistance from the air serves to slow the ball down, until it stops at the very peak. The ball stops at the highest point for just a brief second, and then changes direction and begins to fall. This is easy to understand, because we see it with our very eyes on a daily basis, but if we knew nothing about gravity or air resistance, we could simply track the speed of the ball, and by using some measurement of momentum we could predict that the ball would reverse. Obviously this is not a physics class, but understanding the nature of this will help you to grasp how to properly read a momentum indicator.
Most of the indicators in technical analysis are in one way or another momentum indicators, which will never be able to predict turning points but can add confirmation to previously identified turning points. I have written in the past about using true supply and demand to find a market’s turning points in the future with a high degree of accuracy, but using momentum indicators can help you to feel more confident in your decisions when using levels. The indicator we will look at today is called the Moving Average Convergence Divergence (MACD). Below is a picture of the MACD with the settings 12,26,9:
The MACD is made up of 3 parts:
- The MACD itself (Black Line) – This is the difference between two moving averages, in this case, the 12 and the 26-period moving averages which are not shown. If the 12 and 26 period moving averages are crossing, then the black line will be at the 0 line. Looking to the scale to the right of the chart, it is easy to spot the zero line. If the 12 is above the 26 then the line will be above the zero and indicate a positive value. If the 12 is below the 26 then it will be below the 0 line and indicate a negative value.
- Average (Blue Line) – This is a moving average, in this case, 9 periods of the black line. There are many traders that use the crossing of the blue and black lines as signals to go in or out of trades. I have found this to be very lagging of a system to have much use in practical terms.
- Histogram (red and green bars) – This is the difference between the two lines. If the black is above the blue then the histogram will be positive and read green. If the black line is below the blue then the histogram will be red and below the zero line. When the black and blue lines cross, the histogram will equal zero.
Essentially, the black line is the difference between two averages, the blue line is the average of the difference between two averages, and the red and green bars are the difference between the average of two averages and of those two averages themselves. Simple enough? Clear as mud is what I say.
How Can We Use the MACD to Make Money?
The key is to use it as a momentum indicator. Look at the chart of Apple (AAPL) below:
Notice how, in AAPL the price is making higher highs into a supply zone. The trigger for the reversal of price is the supply zone, not the indicator. Many traders and investors are not confident to sell a strong stock like AAPL in the context of an uptrend, and so they would miss a good potential shorting opportunity as price entered supply. Look at the MACD below, and you will notice that as price is rising into supply and continuing to put in higher swing highs, the MACD is putting in lower swing highs, showing us that the bullish momentum us waning. The reason we are getting lower highs is because the moving averages used to calculate the MACD (which are not on the chart) are getting closer together. Another interesting note is that if you notice current price, we have returned to supply, and the supply is now weaker because the sell inventory is exhausted, but notice that as price is continuing to rise, the MACD also is rising.
The MACD is essentially our momentum indicator, and the speedometer of the ball that has been thrown up in the air. A key to remember that the Supply and Demand levels are what make the decision, and the MACD is simply a decision support tool.
Chuck Fulkerson is the Director of Student Development at Online Trading Academy, a leader in investing and trading education for any market or asset class. Fulkerson helps education individuals across the globe in what it means to be a successful investor and trader. He currently trades options as a swing and position trader; futures and currencies as a day trader; and equities as an investor to round out a truly diversified trading portfolio.