MACD: My Favorite Technical Indicator

"Moving Average Convergence-Divergence" is a mouthful, so "MACD" (Mac-Dee) is the name of my favorite technical analysis indicator.

MACD is all about measuring momentum. It will tell you when buyers have reclaimed control of a stock, or when buyers are getting exhausted and sellers take over. If you trade just MACD and no other technical indicators, you will still have a significant edge when determining a stock's most likely direction.

What is MACD measuring?

MACD is a measurement of the difference between the 26-Day Exponential Moving Average (EMA) and the 12-day EMA. This creates a MACD line. Then, a 9-day EMA, called a signal line) is drawn over it. Points where the MACD line and the signal line cross are indications of changed momentum. MACD will usually include a histogram to make the difference between the MACD and singal lines clearer. These details are for backgrond knowledge only and not necessary for using MACD to trade.

If you are not familiar with moving averages, read this post. Note that the MACD uses the exponential moving average, not the simple moving average. This means that MACD is going to place more emphasis on stock moves that happened recently as opposed to weighting each day equally. This is important because it allows MACD to give us an early indication of when a stock's momentum has shifted.

The histogram just highlights the difference between the MACD line and Signal line to make it easier to identify exhaustion among one side or the exact point where momentum has shifted from a technical standpoint.

How do we use MACD?

There are 3 traditional ways to use MACD.

1) To identify exhaustion among buyers or sellers;
2) To identify when momentum has fully reversed;
3) To identify divergence.

We will go through each other these methods.

1) To identify exhaustion. The MACD histogram displays the difference between the MACD and Signal lines. When the histogram's bars are growing longer (in either direction), then the trend is strengthening. When the bars grow shorter, the trend is weakening. Buyers are becoming exhausted and can no longer sustain an uptrend with as much conviction. Or, sellers are not able to keep the pressure on and buyers are coming into the market and softening the downtrend.

If we recognize when a trend is becoming exhausted, then we have a high probability of entering ahead of a trend going in our favor.

Several times in 2021, AAPL's trends showed exhaustion in momentum. Let's focus on the mid-April shift. In early April, we saw the histogram's bars growing taller after a bullish crossover a few weeks prior (covered in next section). This expansion showed that the bull trend was strengthening and the stock rose quickly. By around April 12, the histogram's bars stopped getting taller. Bulls could no longer sustain the run.

The histogram's bears began to shrink back toward the baseline by April 15. This showed that bulls were exhausted. The stock price remained elevated for a few weeks but stopped rising, as predicted by the buyer fatigue predicted by the histogram. Over the next 2 weeks, bulls lost all momentum and the stock dropped, leading to a bearish MACD crossover.

Traders who recognized the buyer exhaustion on the MACD histogram had an opportunity to enter a bearish position (or exit a bullish one) prior to the stock beginning its bearish trend that dropped the price about 8% and has not yet concluded.

2) To identify when momentum has reversed completely. MACD measures momentum. When the MACD line crosses the signal line in either direction, it serves as confirmation that momentum has flipped, as anticipated by the exhaustion we saw in method 1.

When a stock's MACD line is above the signal line, this implies that the bulls are in control, even if the momentum is starting to abate. When the MACD line is below the signal line, then bears are in control.

Therefore, when the MACD line crosses over the signal line in either direction, it indicates that the former trend is dead and a new one may might be beginning. Of course, the trader should be patient after observing the crossover to make sure it is not a temporary shift that whipsaws back within a day.

At several points in 2021, AAPL's MACD indicated reversal. The reversals in January, the crossovers led to short-term momentum swings, and I am not sure what happened there. There may have been bad news in late Jan that reversed the market or AAPL specifically.

 But in early Feb, the bearish MACD crossover preceded a 6-week trend shift that sent the stock down almost 10%. Crossovers in Mar and late April also predicted trends lasting at least 6 weeks. These crossovers were anticipated by the exhaustion points we saw prior. The MACD crossovers simply confirmed the trend we expected since exhaustion set in.

If you trade just based on MACD crossovers, you have a pretty good shot at being green at some point, even if the stock does whipsaw in the immediate term. If you ensure there is no big event (like earnings) right after a crossover, then you have even more protection against events that force the trend to reverse once again.

3) To identify divergence. This is my least favorite method of using MACD and also the one I understand the least. However it can still be valuable and it does help confirm or strengthen other assessments liek crossovers or trend exhaustion.

When the stock price rises, it should stand to reason that buyers will build momentum while people pile into the uptrend. Likewise, share prices dropping should encourage more sellers to build bearish momentum. 

If that does not happen and bulls or bears never gain high-volume momentum, then the MACD line will display a higher low or lower high, opposite what the price action should indicate. In this way, MACD functions like RSI.

Between early March and mid May, PLTR price suffered a crippling downtrend. However, MACD continued to rise during this time, indicating the bears never truly had control. The histogram remained pretty flat, which indicates low momentum. 

The price action looked highly bearish, but MACD saw that the bears were barely winning the fight. MACD made a higher low around mid-May, even though PLTR hit a new low in price. The higher low on MACD preceded a bullish crossover, after which point the bulls appear firmly in control. 

My issue with this method is that we have no idea how long bears will remain narrowly in control, so we cannot anticipate when the MACD will actually make its new high and predict a bullish crossover. This might be a good method to determine when to stop selling covered calls during a downtrend. Once we start seeing new highs on the MACD, we know our time to sell covered calls is limited and we should not sell at strikes below our basis.

Predictions

I want to make a few predictions based on my MACD analysis to have it on record, and to show that we can use MACD to make predicitons, not just look back for confirmation bias.

AMD experienced a bullish crossover in late May and the bullish trend appears to be expanding because the histogram bars are still growing taller. The MACD also calls out a divergence between early March and late May when AMD price declined but MACD made a higher low.

I predict AMD will continue to climb higher and reclaim its 200-DMA above $84.

PLTR also experienced a bullish crossover in mid-May, predicting a bullish move to reclaim its 50-DMA. Likewise, a bullish divergence appeared between early March and mid-May, just like AMD. 

I predict PLTR will continue rising and reclaim the $30 level.