BannRonn's Stock Trading & Investment

How Professional Traders Catch Trends Using MACD

MACD trend following indicatorThe Moving Average Convergence Divergence (MACD) indicator, developed by Gerald Appel, is one of the most ubiquitious indicators in technical analysis. Most new traders are introduced very early to this indicator through various TA and trading related books like Elder's Trading for a Living & Pring's Introduction to Technical Analysis. Every trading software worth its salt like eSignal, Quotetracker and MetaStock, will have the basic MACD (12,26,9) and the MACD Histogram. Basically, MACD plots the difference between two exponential moving averages (EMAs) and a nine period EMA of this difference as a signal line. For more technical details, go to MACD at StockCharts

How MACD Signals Trades

MACD signals can be used not only to trade stocks, but also futures like the S&P500 e-mini futures (ES), Forex (USDEUR) and commodities like crude oil futures(CL) and Gold (GC). Some of the traditional ways that are used to take signals from MACD are:

  • zero line crossings
  • divergences
  • signal line crossovers
  • overbought and oversold conditions

Mistakes Made in Interpreting MACD Signals

The MACD is primarily a trend following indicator as it can alert traders to a change in trend. Due to its similarity in charts to the Stochastic oscillator, many traders make the mistake of using it like an oscillator and taking every signal line crossover and overbought and oversold condition. This is where the trading account will take a beating because the trader will miss out on the full potential of strong trends and possibly enter trades that are counter to the prevailing trend. The other serious mistake that is often made, especially by new traders, is taking trades solely based on overbought and oversold conditions. New traders to the financial markets do not realize that in strong uptrends, the MACD can remain in the overbought zone for extended periods of time and vice versa for downtrends, it can remain in the oversold zone for lengthy periods. In these instances, buying when the MACD enters into the oversold zone might be premature and part of a bull-trap.

How the Pros Do It

The professional day traders and money managers are cognizant of the fact that the MACD is a trend following indicator, so they will use it to determine the prevailing trend. Many also use price action, trend lines and other trend indicators like ADX and Parabolic SAR to confirm the trend. Once the prevalent trend has been established, they will then use momentum oscilators such as the RSI or Stochastics to further fine tune the entry point. The whole idea is to enter a long position at the turn of a downward retracement during a prevalent uptrend and conversely, to enter a short position during an upward retracement in a prevalent downtrend.

Professional day traders often apply the MACD to a larger time-frame chart like the 5-minute to determine trends, while taking entry and exit signals with RSI or Stochastics on the 1-minute chart.

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