Uses of MACD – Short term trend reversals

The MACD indicator works well in trending markets to provide indication on short term rallies and pullbacks. The challenge is to use them in trading markets where price is choppy and generally moves sideways. When price is volatile in a trading range, it triggers the signal many times and thus providing many false signals because the expected rally did not materialize. We call these whipsaws. Traders and analysts have used various methods and indicators to overcome this whipsaw problem.

One the many signals that can be indicated by the MACD indicator is trend reversal (for the short term). The signal is derived from the relationship between the MACD and its trigger line (The 9 period EMA of the MACD). It is like a relationship between two moving averages.

The signals:

Bullish trend reversal (short term) – When the MACD crosses above the trigger line

Bearish trend reversal (short term) – When the MACD crosses below the trigger line.

Let’s say that the trader decides to make a trading decision when a trend reversal occurs because the trader is anticipating a rally/pullback. The trader makes a buy decision when there is a bullish trend reversal signal and sells when there is a bearish trend reversal signal.
The signals are illustrated in the chart below.

Note that there were whipsaws when price is in a trading range, but works well in a trending market:


Hourly Crude Palm Oil Futures contract price with MACD using NextView Advisor

Identifying trading opportunities using the MACD/EMA crossover.

Trading opportunities can be easily identified using the MACD indicator because the trader just have to wait for the MACD to cross above or below the trigger line to get a buy/sell signal. The chart below shows a chart that provides a buy signal because the MACD crosses above the trigger line.


Daily INTI chart with MACD indicator as at 20 August 2008 using MetaStock.

Can we rely on the buy signal above to make a decision to buy this counter the next day?

Historically, the signal proves to be quite remarkable in providing buy and sell signals and if we have followed the signals, we could have made some money in the above time frame.
The expected outcome is whether the price is going to rally, or it is going to go into a trading range. It is up to the trader to use other methods and indicators to confirm this, but at least we are able to identify potential stocks to trade (opportunities) from the many stocks in an exchange.

If you would like to further understand the MACD indicator and how to use it effectively with other indicators to avoid whipsaws, please attend out technical analysis workshop this Saturday (23rd August 2008) by Benny Lee and you will learn how to use MACD and other indicators to identify trading opportunities and make trading decisions. Call (603) 2770 9388 for more information and registration