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EQUITIES

TRADING TECHNIQUES

Trading stocks with MACD
BY B R A M E S H B H A N DA R I

One of the simplest and most easily analyzed technical indicators, MACD has a number of applications that help you initiate stock trades.

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he moving average convergencedivergence (MACD) originally was constructed by Gerald Appel, an analyst in New York at the time, as a technique for analyzing stock trends. The indicator achieved widespread application by many traders across all types of markets. Today, it is one of the most widely referenced gauges of the market’s technical condition. There is good reason for this. MACD is one of the simplest and most intuitive indicators available. Over time, it has demonstrated a satisfying level of reliability. While not always perfect, of course, when MACD doesn’t signal precise entry and exit points, it usually conveys valuable information about the general state of the market — bullish or bearish — and points traders in the right direction.
Directional indicators Divergence & crossovers

MACD is constructed by subtracting a longer moving average from a shorter moving average. A moving average is simply the average value of prices over the most recent N days. The shorter average is believed to be more responsive to price changes; the longer average is considered less responsive. By subtracting the value
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FUTURES December 2011

of the longer moving average from the value of the shorter moving average, we generate the difference. This can be plotted by itself below the price chart. The plot will oscillate above and below zero, with (theoretically) no upper or lower limit. In addition to the MACD, the oscillator chart often includes two other plots. One is the signal line, which is just a moving average of the MACD itself. The other is a histogram. The histogram is just a visual aid, indicating how far the oscillator is from its signal line. Traders typically speak of a “fast” MACD and a “slow” MACD. For our purposes, we’ll consider a fast MACD one that uses shorter moving averages (say, five and 10 periods) to produce a quicker, more responsive indicator. We’ll consider a slow MACD one that uses longer moving averages (say, 12 and 26 periods) to produce a slower indicator, but one that is less prone to false signals and whipsaw-type action. Most charting packages have a default of 12 periods for the fast-moving average and 26 periods for the slow. MACD remains a viable method for analyzing both stock trends and identifying short-term changes in market trend, particularly in both the overall stock market and individual stocks.

Understanding MACD For our MACD, we’ll turn to the 12- and 26-day averages. Instead of simple moving averages, we’ll use exponential moving averages (EMA), which are calculated to reflect prices over the stated period but emphasize more recent values. A positive MACD is generated when the 12-day EMA is trading above the 26-day EMA. A negative MACD indicates that the 12-day EMA is trading below the 26-day EMA. If MACD is positive and rising, then the gap between the faster moving average (blue) and the slower moving average (red) is widening (see “MACD in the S&P,” right). This indicates that the rate-of-change of the faster moving average is higher than that of the slower moving average. Positive momentum is increasing, indicating a bullish period for the price plot. Included in “MACD in the S&P” are the 12- and 26-period EMAs. Notice how MACD indicated a buy signal several bars before a basic moving average cross. If MACD is negative and declining, then the negative gap between the faster moving average (blue) and the slower moving average (red) is expanding. Downward momentum is accelerating, indicating a bearish trading period. MACD centerline crossovers occur when

If these aren’t used in conjunction with other technical analysis tools. the trader following them can fall victim to numerous false signals. negative divergence is the most subjective of the three common bearish signals. This signal is generated when the MACD moves above the zero line and into positive territory (see “Bull move. Bullish/bearish signals There are a number of bullish signals generated by the MACD.the faster moving average crosses the slower one.” page 34). a nine-day EMA). a bullish moving average crossover and a bullish centerline crossover. They can be broken down as positive divergence. and lead to the biggest moves (see “Technical divergence.com 33 . The bullish centerline crossover is another somewhat common occurrence. Positive divergences probably are the least common of the three signals. and the MACD declines. As with bullish divergence. It tells us that price momentum has changed from bearish to bullish. S&P 500 137500 135000 132500 130000 127500 125000 122500 120000 117500 115000 112500 110000 107500 105000 102500 100000 20 10 0 MACD histogram MACD minus the MACD signal link MACD Signal MACD 12-period EMA minus 26-period EMA Jul Aug Sep Oct Nov Dec MACD signal Line 9-period EMA 2011 Feb Mar Apr May Jun Jul -10 -20 Aug Source: eSignal TECHNICAL DIVERGENCE When MACD moves higher (or lower) and the price of the stock or index fails to respond.” right).” page 34). Negative divergence in MACD can take the form of either a lower-high or a straight decline. Negative divergence forms when the index or security advances or moves sideways. this is known as divergence and indicates a potential price move. Signal line crossovers are the most frequent signals given by the MACD (see “Signal line cross. A positive divergence occurs when MACD begins to advance and the index or stock is still in a downtrend and makes a lower reaction low. Nasdaq Composite Positive divergence in Nasdaq observed with index making lower lows and MACD making higher highs 2600 2550 2500 2450 2400 2350 2300 2250 2200 2150 2100 2050 50 25 0 MACD signal -25 -50 Apr May Jun Jul Aug Sep Oct Nov Dec Source: eSignal futuresmag. These are known as negative divergence. as shown here in the Nasdaq Composite. The mirror of the bullish signals can be used to identify potential bearish turns in the stock market. Also notice how MACD indicated a buy signal several bars ahead of a simple moving average cross. Negative divergences probably are the least common of the three sig- MACD IN THE S&P The late-August cross of the MACD histogram into positive territory is a stellar example of the indicator forecasting a strong trend in the S&P 500. A bullish moving average crossover occurs when MACD moves above its signal line (in this case. bearish moving average crossovers and bearish centerline crossovers. but usually are the most reliable.

One of the beneficial aspects of the MACD also is one of its drawbacks.” right). but usually are the most reliable and can warn of an impending peak (see “Before the fall. As on the bullish side. this is a clear indication that momentum has changed from bullish to bearish. Apple Inc. IBM MACD going above zero line. As with all indicators. In any case. As a momentum indicator. The use of moving averages ensures that the indicator eventually will follow the movements of the underlying security. MACD is not infallible and should be used in conjunction with other technical analysis tools. A bearish moving average crossover occurs when MACD declines below its signal line. momentum. has turned bearish. The effectiveness of the MACD will vary for different securities and markets. Even though the MACD BULL MOVE When MACD went positive. volatility measures or cycle analysis. 430 420 410 400 390 380 370 360 350 340 MACD moving above 9 EMA line and Apple starts its BULL run 330 320 310 MACD Signal 15 10 5 0 -5 Apr May Jun Jul Aug Sep Oct Source: eSignal nals. For example. once MACD crosses into negative territory. the more common signals are the bearish moving average crossover and the bearish centerline crossover. Of course. be they simple. Often. it is considered a bullish development.5 0 -2.TRADING TECHNIQUES continued SIGNAL LINE CROSS The red signal line is an EMA of the MACD plot. crossovers are common and can give frequent false signals.5 Apr May Jun Jul Aug Sep Oct Source: eSignal 34 FUTURES December 2011 . or those that occur at recent extremes in the MACD itself. as shown here with Apple. IBM responded with a solid short-term rally. IBM gaining positive momentum 190 185 180 175 170 165 160 5 MACD Signal 2. As you can see in the indicator plot. at least for the short-term. all of these analysis approaches can be modified in a number of ways. a centerline crossover can act as a confirmation of either a moving average crossover or negative divergence. such as trendlines. When the MACD moves above it. A bearish signal line crossover occurs when MACD moves below its zero line and into negative territory. For example. Strengths & weaknesses The primary strengths of MACD are that it incorporates aspects of both momentum and trend in one indicator. MACD has the ability to foreshadow moves in the underlying index or security. exponential or weighted. Moving averages. you might place different weight on signal line crossovers that occur in positive or negative territory. are lagging indicators. MACD divergences can be key factors in predicting a trend change.

28 for $5. this analysis will come down on the side of the spread. Breakeven on this trade can be calculated by subtracting the cost of the trade from the long put’s strike price.50 a share. The options are pretty expensive. so a bear put spread makes sense.25). it’s $311.75). The maximum profit goal of the bear put spread is to have the stock trading below the sold put’s strike at November expiration.com. The maximum profit potential on the trade is $6. John Kmiecik has worked for several firms.44 for $9 and sell the OTM November 305 put with a current delta of 0.44 . which means the trade will make or lose 16¢ for every dollar the stock goes up or down. Just like what was shown in the bullish example. This is more likely to be the case with weekly charts rather than daily. The trader can buy the November 315 put (just OTM) with a current delta of 0. Vertical debit spreads are a relatively easy to understand and pretty straightforward option strategy. Some traders avoid the MACD because it has achieved widespread use in the markets.16 (0. Currently. and JPM down to $39 from high of $48. but if the stock rallies even more.5 0 -. move on.25 ($10 . if the November 315 put were bought on its own. Of course. But for most stock traders.0.$3. The cost of the spread is $3. MACD can point you in the right direction. this can be a disadvantage. He can be reached at: bhandaribrahmesh@gmail.represents the difference between two moving averages. With this strategy in your arsenal. which was one of the concerns. Just like any other option strategy. This was preceded by a clear negative divergence between price and MACD. including Goldman Sachs and First Options of Chicago. When deciding whether to buy just calls or puts.05 -1. he is an options coach for Market Taker Mentoring LLC. the breakeven on the trade would be $306 ($315 .75) at November expiration. Currently. This would be achieved if ZZZ finished below $305 at November expiration. the pros and cons of each have to be debated. each has advantages and disadvantages. and the trader worries that the stock might keep rising. the delta on the spread will widen. the goal of the trade remains the same: For the stock to trade over the sold call’s strike by December expiration.$3.com 35 . if an indicator isn’t working for you. which is the difference in the strikes minus the cost of the trade. It’s Oct. however.0 Aug Sep Oct Nov Dec 2011 Feb Mar Apr Source: eSignal JP Morgan moving up but MACD forming lower-high formation and negative divergence. In this example. there still can be some lag in the indicator itself. Again.75 ($9 – $5. 49 48 47 46 45 44 43 42 41 40 39 38 37 36 35 MACD Signal 1. An option trader believes the stock is overbought and might decline over the next month. you now can be prepared for those times. Perhaps familiarity has bred contempt or they believe that the indicator’s signals are discounted by the markets. which is quite a bit more. not assumptions or unproven biases. It shouldn’t be your only tool.25. However. the delta on the spread is 0. TRADING TECHNIQUES continued Trading Techniques: Kmiecik continued from page 31 options get closer to expiration. but base it on first-hand experience. JP Morgan Chase & Co. which is the most the trader can lose if the stock finishes above $315 by November expiration (see “Bear put debit spread. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade.0 0. or to buy a vertical debit spread.” page 31). Often. and has traded professionally for hedge funds. Bearish scenario A bear put spread (bearish vertical debit spread) involves buying a put option and selling a lower strike put. BEFORE THE FALL JP Morgan initiated a steady and prolonged decline in early to mid-2011. the trader will lose less on the spread than by just being long the puts.$9). futuresmag. but it’s definitely one worth keeping at the ready. The most the option trader can lose is the cost of the spread.28). 25 and ZZZ stock is trading at $318.25 ($315 . E-mail him at john@markettaker.com. Bramesh Bhandari trades the Indian stock market and teaches technical analysis to traders. You may believe this is so.