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MACD = Moving Average Convergence/Divergence

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The Moving Average Convergence/Divergence is a good medium term indicator developed by George Appel that signals overbought and oversold conditions by measuring the intensity of public sentiment. Use the crossover of the fast moving average through the slower moving average to arrive at buy or sell signals. MACD is especially valuable when used in conjunction with a momentum indicator such as Stochastic or RSI. Since MACD is a sensitive indicator of public sentiment it can be applied to mutual funds as well as stocks and some technicians believe a 8-17-9 MACD is best for entering long positions and 12-25-9 for exiting them.

The first thing to check out when you're interested in a stock is the trend. Why? Because you make money by riding out stocks that are trending. After getting the initial impression of which direction a stock is trending you should always study the MACD (Moving Average Convergence-Divergence) graph. The MACD graph has a fast line (the blue one) and a slow signal (the red line). The crossing of the blue line over the red can denote the beginning of a trend.

The up trend typically stops when the red line crosses above the blue. Where the crossover happens tells you if there is a trend and how strong it is. When the blue fast line crosses over the red line, at or above the centerline (which serves as a constant at a zero value), the stock is trending hard - a definite candidate for a long position! The higher above the centerline it crosses, the stronger the up trend is. If the crossover occurs below the centerline, the up trend indicated is not nearly as strong.

Understanding MACD boils down to one thing: being able to understand the relationship between its two lines, the fast line (in blue) and the slow signal (in red).

Each line is a moving average.

The fast line results from the difference of the long- and short-term moving averages. To be more precise, the 26-day EMA of the closing price (the long-term moving average) subtracted by the 12-day EMA of the closing price (the short-term) gives you the calculation for the fast line.

The slow signal is a moving average of the fast line. You derive the slow signal by calculating the 9-day EMA of the fast line. Just by watching how these two lines interact, you can scrape up huge amounts of information about a stock. The two most important things to watch are the meeting and crossing over of the lines and where in relationship to the centerline they crossover.

Crossovers and the Centerline

Crossovers can signify trends. For example, the blue line crossing and rising above the red line could signal the start of an up trend. Likewise, the red line crossing over the blue could be the start of a downtrend. What determines whether the crossover is strong enough to signal a trend is where it happens. This is what's important. The centerline is the key, where a crossover happens in relation to the centerline can offer a strong indication where that stock is going.

When the blue fast line crosses over the red slow signal above the centerline, that is a good indication of a bullish trend. The higher up above the centerline the lines cross, the stronger the trend acts.

When the red line crosses over the blue above the centerline, it does not necessarily mean that there is a big downtrend headed our way. It can also signify a pause in the current up trend. The stock could be taking a breather before it lifts off again. This can happen often.

If the blue line crosses over the red line below the centerline, it can mean that the downtrend is stopping out (or pausing), or it could be that things are turning around and the stock is heading for an up trend. However, because the crossover happened below the centerline, the trend probably won't be too strong.

The red line crossing over the blue below the centerline is a good sign of the beginning of a downtrend. Keep in mind that the further below the centerline the crossover takes place the stronger the trend!

The MACD Histogram is used in conjunction with the MACD graph. When the fast line on the MACD graph (the blue one) is sailing over the signal line (the red), the bars on the Histogram are drawn above its centerline. When the red line is over the blue, the bars are below the centerline. The slope of the bars gives you a better idea of how strong a trend is: as a trend picks up momentum, the bars progressively grow longer.

As it slows down, the bars get shorter and shorter. The beauty of the Histogram is that it signals reversals in trends. What does that mean? Well, sometimes signals can be deceiving; you may think a stock is doing really well when in reality it's going to take a nose-dive. What to look out for:

When a stock breaks a record price high but the Histogram is only slighly responding in tiny bars, bad sign! Sell. Basically, it means that though at the moment the bulls are showing off their strength, the bears really have the power and are in control of the situation. When a stock hits a record low and the Histogram is smoldering below the centerline, it's a good idea to look into buying that stock.

There is no substitute for looking at graphs and pattern matching in your mind. In fact, everything you need to know can be learned by looking at a lot of graphs. And the MACD graph is one of the most informative! MACD looks at the interaction of two moving averages. The long-term moving average is 26 days, the short-term is 12 days.

When prices accelerate from either a trough (which is some drastic sort of price decline) or a retracement (a more healthy movement sideways which doesn't violate that basic rules of uptrend), the shorter-term moving average overtakes the longer term one, crosses over it, and then moves beyond. The difference between the long term and short term moving average is the fast line, drawn in blue. The MACD Histogram gives you a way to determine its strength. A smoothing (or rate of change) of this line is the slow line (drawn in red).

When the fast line crosses above the slow line, prices are diverging and accelerating on the upside. Divergence simply means a significant change in behavior.

When a crossover occurs, it's examined to see if the crossover occurs above or below the centerline. Crossovers below the centerline are ignored. A stock is deemed to be weak if the gravity of the retracement (or trough) is serious enough to pull the MACD lines below center. Strong stocks stay above center for years at a time. Those that get hit hard enough to pull the lines below center are therefore deemed not worthy of consideration.

So, crossovers below center are ambiguous. What happens when a crossover occurs below center? It's not thrown out. This fact is noted. The crossover could have occurred just a touch from center, so it's just a matter of one more day that carries it forward enough to "go positive." Once things go positive, a signal is raised. This is not a strong signal. Crossovers that originate below center must be taken with a grain of salt. But currently, not throwing them out is considered a good move.

Again, look at the graphs. If you see a stock where the MACD lines are below center and you can see declines in the price graph, this is clearly a time to look elsewhere.

Crossovers above center are flagged if the rate of divergence (between the fast and slow lines) is significant. This gives birth to a up trend. Timing is everything. Ignore price action at your expense. What you should get out of the knowledge of whether a stock is in an up trend or down, is a clue to whether you should wait, or whether it's time to jump. Urgency, or worrying about missing out on this, that, or the other thing, should never have to enter the equation. That's the goal.

When the fast line crosses below the slow line, prices are diverging on the downside. This can be a downtrend signal to occur. The exception is if this cross below occurs above the centerline. This usually indicates a trend is either pausing or simply slowing down. Cross-belows that occur below center, signal a downtrend could immediately begin. This mirrors up trends on crossovers above center.

If a cross-below occurs above center, it is not thrown out, but noted for the record. The Trader then waits to see if the progression takes the MACD lines below the centerline, or if a rapid breakdown in prices occurs. If they do or this does, a downtrend is likely. This mirrors action on the cross-above side of the equation. So, treatment in the bullish case (cross above) and the bearish case (cross below) is symmetrical.

There are many heuristics thrown in (the Trader gets more aggressive on stocks with a demonstrated tendency towards either strength or weakness.) The Trader also starts to shut down for stocks that move meaninglessly across a flat plane. That's generally how things work, so you should be able to start making sense of the MACD and the up and downtrends.


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