Moving average convergence-divergence (MACD)

The moving average convergence-divergence (MACD) is a trend indicator that subtracts the slow moving average (long-term) from the fast moving average (short-term). Please consult moving averages for more information on slow on fast moving averages.

Let's go into the details of the MACD as a trading tool in the case of an uptrend (which implies going long on a stock). You can easily deduce the mechanics of shorting a stock using the MACD in case of a downtrend. Be aware that shorting a stock is tad riskier than longing a stock since the losses can be (in theory) infinite.

In an established uptrend, the MACD is positive since the fast moving average is above the slower one. What's interesting is that the MACD goes up (MACD's own uptrend) when the two moving averages diverge and goes down (MACD's own downtrend) when they converge, hence the "convergence-divergence" in the name of the indicator. If you convince yourself that the best time to exit a long trade (which you entered in the hope the price will go higher) is when the two moving averages start to converge (instead of waiting until they actually cross), then it makes sense to exit when the MACD's uptrend is over.

How do you detect when the MACD's uptrend is over? It's the exact same principle as when you are trying to detect the end of a price uptrend using its moving average. Indeed, you detect the end of the MACD's uptrend (not to be confused with the stock price's uptrend) with a moving average (of the MACD)!

The moving average of the MACD is called the signal or trigger line. When the MACD crosses above its average, the MACD is in an uptrend and that's where you should buy (assuming you are going long). When the MACD crosses its average to the downside, you sell the stock. By using the MACD and its trigger instead of the two moving averages, you enter the trade a tad late but exit the trade much earlier, closer to the actual reversal (if all goes well).

The MACD cannot really be used alone as a trade decision tool (although some people do). It should be considered along with other indicators.