I always enjoy interacting with my readers. It allows me to share things I’ve learned over my 40-year career.
So today, let’s tackle a question a reader sent in on the Moving Average Convergence/Divergence (MACD) technical indicator.
Steve D. wrote…
Larry, thank you so very much for all of this educational material you sent out to us to learn how to trade options more safely and profitably. I have learned so much from reading your material, and my trading results have definitely improved by following your guidelines.
I do have a question related to the MACD:
When you are looking at the daily time frame, which is the best option to choose?
One minute?
Five minutes?
10 minutes?
15 minutes?
Which one do you typically use?
Each will give you a dramatically different picture of the momentum of the stock. Please advise.
Thanks for writing in, Steve.
To begin, let’s do a quick recap of what the MACD tells us…
First, the MACD helps traders identify a stock’s change in direction.
That’s key to the mean reversion strategy that I use. I look for stocks that have overshot in one direction and aim to profit when they reverse back the other way.
Second, the MACD is also useful to trend traders. It helps identify the start and end of a trend.
Traders often use the MACD in conjunction with the Relative Strength Index (RSI) to better clarify these moves.
I’ll show how this works with an example…
How to Use MACD and RSI
Let’s check out the chart of VanEck Semiconductor ETF (SMH):
VanEck Semiconductor ETF (SMH)
Source: e-Signal
In the bottom section of the chart, the blue line (referred to as the MACD line) plots the difference between a 12-day and 26-day exponential moving average (EMA).
Unlike a standard moving average, the EMA places greater weight on the most recent data.
The orange line is called the signal line. It is a 9-day EMA of the MACD line. The histogram in the middle (black vertical lines) represents the difference between the blue and orange lines.
The histogram retreats to zero as the two lines converge. That’s often a precursor to them crossing over.
In broad strokes, a bullish signal occurs when the MACD line crosses above the signal line. And a bearish signal occurs when the MACD crosses below the signal line.
To see how we can apply the MACD in the SMH chart, look at the brown circles…
The ‘V’ in the RSI at oversold territory (lower brown circle) coincides with SMH’s trough (upper brown circle). At the time, these signs pointed to a potential reversal higher.
But a single signal often isn’t enough to be confident about a move.
So the MACD adds further clarification and confirmation.
Take another look:
VanEck Semiconductor ETF (SMH)
Source: e-Signal
As you can see, the MACD line reversed direction and crossed back above the signal line (see black arrow). Both then trended higher, confirming the up move.
Then we can see another example of the MACD’s usefulness when SMH topped out in July…
Look at the divergence between the stock price and RSI (upper and middle green lines). This warned of a potential reversal. It’s a common chart pattern to look for.
On top of that, the divergence between the MACD (lower green line) and the stock price provided another good signal. It also suggested that the up move was ending and could reverse.
The MACD line crossing and accelerating below the signal line confirmed SMH’s down move from July to August.
These crossovers and diverging patterns make the MACD a versatile tool for traders.
Yet as Steve mentioned, sometimes traders want to refine the MACD’s settings. It’s a little complicated, but stick with me…
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Adjusting the MACD for Your Trading Style
There are two ways to adjust the MACD.
The first way is by choosing a different chart time frame, like Steve mentions. This could be a 15-minute or 60-minute chart – or a daily or monthly chart.
And you can experiment to find the timing that suits your trading style.
As you experiment, keep a couple of rules in mind.
The first rule is to use a time frame that reflects your trading strategy.
If you’re aiming to hold a position for a few days or weeks, then a daily chart is normally the best way to go.
But if you’re trading in and out of positions in a day or less, then you can use a shorter time frame – like 30 minutes or one hour, for example.
There is no one-size-fits-all.
I’d suggest paper trading time frames to find the one that best works for you. The process of elimination can help you rule out time frames that don’t serve your purposes.
The second rule is that you must be consistent.
Once you’ve decided on the time frame that suits your strategy best, you need to stick with it.
Using different time frames will ultimately only lead to confusion (for example, don’t enter a trade using a 30-minute signal and exit using a daily signal).
That will end up costing you money.
Then we come to the second way to adjust the MACD.
Though you didn’t explicitly ask about this, Steve, it’s important to know all your options.
The second way is EMA settings.
Note that the 12-day/26-day EMAs for the MACD line and the 9-day EMA for the signal line are the standard settings for the MACD.
But traders can also adjust these to suit their needs.
Faster EMAs are more sensitive to price changes and short-term trends. But they may pick up more false signals. Slower EMAs, on the other hand, are better for longer-term trends and produce fewer false signals, but they can have a slight lag in picking up on changes.
So in the end… you can use chart time frames or different EMAs to refine the MACD for your trading. Either way, I recommend experimenting as I described above.
With a little trial and error, you can find the best settings for your needs.
I hope that helps Steve, and thanks again for writing in.
And if any readers have a question that they’d like me to address in a future essay, please send it to feedback@opportunistictrader.com.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict