MACD Readings That (Actually) Improve Accuracy

One of the most popular and yet misused technical indicators, I feel, is the MACD (moving average convergence divergence). Being one of the most common indicators in charting packages, the MACD gets a lot of interest from amateur investors. One the surface it's a very simple signal generator and to the unlearned that simplicity is appreciated. However the problem with how most novices use the MACD is that they place too much importance in the basic crossover signal.

AAPL with Weekly MACD

 The MACD is essentially two moving averages and their relationship to each other; there is a moving average convergence line and then another "signal" line that is more sensitive to short-term price movements. The common use of the indicator is to buy or sell when the moving average line crosses above or below the signal line. Because this is the easy way to use this tool most just hope to take the shortcut and get rich. But the market is no dummy, if something were that easy then everyone would be rich. In fact if you were to simply take the crossover signal as your entry/exit criteria you would have a really hard time achieving any sort of sustainable return over time. Sorry folks, there's no easy way out.

The MACD is much better used as a trend health indicator and momentum signal. To add this indicator to your trading arsenal you have to interpret what the MACD is saying and not just flop your positions around each time the lines cross each other. The key thing to realize about the MACD indicator is that it is simply there to alert you to when the trend is turning from negative to positive and vice versa. It's hard to rely on it solely as a trade generator but used in conjunction with other price based signals, the MACD can add to increased trade success. 

My primary methods of use for the MACD are:

1. Momentum Divergences

2. Intermediate-term Trend Reversals

In my analysis I combine these two methods to create a high probability trade entry. These signals can be generated across any timeframe, but my preferred timeframe is with Weekly charts. 

When you open the MACD indicator you will notice the two signal lines and then another horizontal "zero" line showing whether the MACD is positive or negative. How the MACD behaves around the zero line is the key to using the indicator correctly. The hard part is that no two instances look exactly the same and the skill of the trader goes a long way in identifying the best setups. They say technical analysis is more of an art than a science and in this case that is absolutely correct.

What we want to look for are MACD pullbacks/corrections from above the zero line back into the zero area. When the MACD lines are above zero the stock is believed to be in a bullish posture, when the MACD is below zero it is said to be bearish in nature. What we want to see is when that pullback occurs, that it bottoms out and reverses above the zero line. It can dip below briefly, but we want that bullish crossover signal occurring after the zero area test holds. 

Generally it's not the initial move from below zero to above that generates a high probability setup, but rather once that move above occurs, price will consolidate as will the MACD. The important signal is when the consolidation holds at zero and then turns back higher. This shows that the pullback was just that, a consolidation of the previous uptrend and it is now resuming even stronger. I find this pattern to be highly accurate and profitable.

US Steel basing structure and behavior around zero line

When combined with a price breakout and Relative Strength confirmation, some of the best moves in the market come from this setup with exceptionally low risk of failure. 

I find this method works best on large, long-term base formation breakouts and on corrections of longer-term uptrends. So depending on your investing methods the signal can be used for long-term value reversals and also for trading big winners after they have regressed back to their trend average.

Yahoo after big rally and pullback, Up trend is intact.