O.

Senhadji
Spotting Trend Reversals With MACD
London, 2013

MACD divergences are considered one of the most powerful ways to

trade with MACD. The idea of a divergence is the same with many other
oscillators (like RSI, Momentum, or Stochastics).
Trading Education O. Senhadji El Rhazi

Table of Contents

Introduction .......................................................................................................................... 2

MACD (Moving Average Convergence/Divergence)......................................................... 2

Trading overbought/oversold market with MACD ............................................................. 2

Nature of Momentum ............................................................................................................ 2

The MACD definition........................................................................................................ 3

Channeling the MACD ...................................................................................................... 3

Spotting a Reversal ............................................................................................................... 5

Increasing Profitability on Reversal Bets ........................................................................... 6

The Bottom Line ............................................................................................................... 6

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Trading Education O. Senhadji El Rhazi

Introduction
Many trading strategies are based on a process, not a single signal. This process often involves
a series of steps that ultimately lead to a signal. Typically, chartists first establish a trading bias
or long-term perspective. Second, chartists wait for pullbacks or bounces that will improve the
risk-reward ratio. Third, chartists look for a reversal that indicates a subsequent upturn or
downturn in price. Just like stock prices, momentum will trend. Momentum changes precede
stock price changes. This article is designed to help you spot trend changes in momentum and
stock price.

MACD (Moving Average Convergence/Divergence)

If there were ever a quest in the world of investing on par with the search for the Holy Grail, it
would be acquiring the ability to spot trend changes. There are many ways investors attempt to
do this with varying degrees of success, but a common trend-tracking tool is the two-line
moving average convergence divergence (MACD).

MACD is built on exponential moving averages, which make many people immediately think
about trend following, there are also ways to use the MACD for counter-trend trading and
spotting probable reversals. This tool measures a stock's momentum and can aid investors in
spotting changes in market sentiment.

Trading overbought/oversold market with MACD

Thought officially the MACD indicator has nothing like overbought and oversold levels and
the values it can reach are not limited by any certain number, it is possible to use the MACD
for identifying when the markets momentum may be overheated on one side or the other.

However, it is quite difficult to define hard fixed rules for such strategy. Trading it successfully
requires a good familiarity with the behaviour of the market you trade especially knowing
which MACD levels are usually too far away from the zero line and might therefore signal
high probability of a pullback towards it (a correction in the current trend).

Nature of Momentum
Momentum in charting is similar to momentum in physics; if you throw a ball in the air, it will
ascend at a slower and slower pace the higher it projects. After monitoring the changing

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momentum, a person can determine when the ball will stop climbing, change direction and
descend.

Just like in physics, momentum changes occur before the price of a stock changes. These
momentum changes can be easily observed using the MACD (mack-dee) indicator. (Buy high
and sell higher.

The MACD definition

Gerald Appel developed the MACD indicator in an attempt to chart momentum by measuring
the increasing and decreasing space between two exponential moving averages (usually the 12-
day and the 26-day). If the distance between the two moving averages is diverging, then
momentum is increasing, whereas if the moving averages are converging, then momentum is
decreasing. The distance between the two moving averages is graphed in what is called a
MACD line (black), as seen in Figure 1.

Two-line MACD

To confirm changes in momentum, a nine-day exponential moving average is added as a signal

line (the red line in Figure 1). A buy signal occurs when the MACD line crosses above the
signal line. The sell signal occurs when the MACD line falls below the signal line. In an attempt
to optimize these signals, it was found that 12- and 26-day moving averages for long-term
signals and seven and 18-day moving averages for short-term signals were ideal.

Channeling the MACD

The practice of drawing trendlines on a stock chart is as almost as old as buying stock itself,
but what you may not know is that you can also draw trendlines on the indicators, such as the
two-line MACD. Drawing a support and a resistance level at the same time creates a channel
of action that helps measure the trend's current strength.

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In Figure 2, we measured the stock's trend strength by creating a channel. To create the channel,
draw support by connecting the bottoms and determine the return line by connecting the tops
of the MACD.

In November 2008 and then in February 2009, the MACD created lower highs while the stock
price created equal highs; this is called divergence and tells investors that the stock is losing
momentum. Investors could choose short positions when the MACD line bounces down off
resistance. The short position may be covered when the MACD line reaches support at the
channel's bottom or for long-term trades when the channel is broken, like it was near the end
of April 2009.

Figure 2: Bearish divergence and trend

If we had looked at Figure 3 in July 2008, we may have noticed that the MACD was making
higher lows and diverging from the stock price. This phenomenon is signaling a possible
reversal. In November, the reversal was confirmed when the MACD created a major higher
low, demonstrating a buildup in bullish momentum.

January 2009 saw the stock make a brand-new high when it broke long-term resistance;
however, the MACD showed that momentum wasn't confirming the breakout. The MACD kept
falling as the stock attempted to establish support near the $80 level. When the stock broke
support, the MACD broke its support line, confirming that the stock would not maintain its
current price level and investors should sell their shares.

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Figure 3: Bullish divergence and trend

Spotting a Reversal
The strength of the current trend can be measured by channeling the MACD. Spot trend
reversals by looking for divergences in momentum as measured by the MACD channel.
Determine buy and sell signals using the MACD crossovers or bounces off the channel's lines.
Learning to implement and recognize these signals helps investors increase their profits when
trading short and intermediate-term trends.

The Challenges of Spotting a Reversal

Simply put, a reversal occurs when a stock changes trend and starts to move in the opposite
direction of previous price action. Psychologically, reversals can incredibly difficult for even
the most experienced investors to react to. Thats because in the early stages of a reversal, the
markets still showing many indications of a continued move in the original direction.

The market meltdown of 2008 was a good example of a powerful downtrend that was difficult
to spot the end of. While the lows of March 2009 are easy to spot with the benefit of hindsight,
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it was considerably more difficult to go long stocks in 2009 after the market had already
punished bulls so fiercely in the preceding year.

But by the time skittish mainstream investors had piled onto the stock-buying game, a
significant chunk of the markets initial move was already behind it. Improving reversal
recognition is one remedy for that.

Naturally, markets arent always trending -- quite often, markets can trade without a
discernable direction. Spotting reversals in ranging markets is important too; not only can
reversals tell you when a major trend may be about to begin, they also can be a shorter-term
trading opportunity for more active traders.

Increasing Profitability on Reversal Bets

Because spotting reversals isnt foolproof, its important to use smart risk management
techniques to avoid getting hammered if a potential reversal fails. The easiest way to do this is
with well-placed stop losses (hard or otherwise) just inside the stocks trend line. Dont ever
try to top tick a reversal by betting against stocks while theyre still in uptrend mode --
waiting for the reversal to actually occur, then capturing the meat of the move, is a significantly
more profitable strategy.

While spotting reversals early can significantly improve your ability to profit in both bull and
bear markets, its likely one of the most difficult (and sought after) skills to master in technical
analysis. As with most disciplines, practice is key.

The Bottom Line

The strength of the current trend can be measured by channelling the MACD. Spot trend
reversals by looking for divergences in momentum as measured by the MACD channel.
Determine buy and sell signals using the MACD crossovers or bounces off the channel's lines.
Learning to implement and recognize these signals helps investors increase their profits when
trading short and intermediate-term trends.