Education: Momemtum Investing

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MACD and Momentum: A Powerful Combination

The moving average convergence-divergence indicator, or MACD for short, is a very popular technical tool used to determine trends in momentum. It is calculated by taking the difference between two exponentially smoothed moving averages of 26- and 12-days. A moving average of 9 periods is calculated of this differential, which is named the "signal line". The MACD line will be quicker to track the most recent price changes due to exponential smoothing, which weights the most recent changes more heavily than earlier ones. In contrast, the signal line is simply a moving average of the last 9 values of the MACD and therefore, is not weighted. Sometimes a histogram is included which shows the difference between the MACD and the signal line. If the MACD is above the signal line the values are positive and the rate of change for the faster moving average (12-day) is higher than the rate of change for the slower moving average (26-day). This would indicate increasing positive momentum and price acceleration- definitely a bullish development. The opposite holds true if the values are negative, or the MACD is below the signal line- downward momentum is increasing.

How To Use the MACD Indicator

There are two primary ways to use this popular technical indicator. First, the MACD can be used as a crossover signal. For instance, if the MACD crosses above the signal line, it is typically a bullish signal, suggesting the price of the stock is likely to experience upward momentum. Conversely, if the MACD crosses below the signal line, it is a bearish signal, possibly forecasting a pending reversal. The second way investors can use the MACD is by watching for a move above or below the "0" line. If the MACD is above this line, the short-term moving average is above the long-term moving average, signaling upward momentum. The opposite is true if the MACD is below the "0" line. It is important to remember that there are no guarantees regarding MACD analysis or any other technical indicator. In fact, many traders use the MACD in combination with other indicators to help reinforce their buy and sell decisions.

The MACD in Action

Lets now turn our attention to an actual example of the MACD crossover that occurred in a six-month chart for Terra Industries earlier this year. In late July and early August, TRA was in a minor downtrend as prices leveled off in an overall weak market. On Aug 10, shares of TRA found their bottom and once again headed higher, and the MACD crossover was not far behind. Within only a couple of session the short-term moving average once again accelerated above the long-term moving average, providing investors with an indicator that prices were headed higher and giving the signal to initiate. TRA then proceeded to move from $20 to a high of just under $40, close to a 100% gain. That is a serious return in a very short amount of time. When the market topped off and once again dipped lower, the MACD signaled that the rally was over, with the short-term moving average once again relaxing beneath the long-term moving average.

The same buy signal was once again generated in mid December as shares of TRA gained strength and pushed to a new 52-week high. So as you can see from these charts, the MACD can be a very powerful tool to assist investors in identifying a shift in underlying price sentiment and movement.