I hope you've had a good couple of weeks trading. It has not been a kind period to buy and hold stocks. The market is very sensitive to news right now and the slightest bit of news has caused another wave of selling frenzy. However, I think the market has become a bit more calloused to these changes recently. After all, how many more reports do we need to inform us that the economy stunk in the fourth quarter?

In today's e-zine, I want to look at an indicator that has become "the indicator" for a lot of stock traders. That's the MACD. I suppose it's the attractive swooping feature that gets people's attention. At times, it seems to so perfectly mirror price activity that you could just sit back and use that one indicator and make a fortune in the market.

Unfortunately, it's not quite that easy.

First off, it's important to recognize that the MACD is a trailing indicator. That means that it only tells us what has already occured. It does not predict future price movement. I'm not going into the exact formula for MACD here. But, suffice it to say that it uses Exponential Moving Averages in a mathmatical formula designed to show larger trends in price movement.

As you know by now, I have focused a great deal of attention on trading the morning gaps - gap ups and gap downs. When I first began studying the MACD in relation to gap downs, I thought a confirmed bottom always meant that a recovery was imminent. But I soon found that was incorrect.

Let me show you two charts to illustrate this lesson. Both stocks are from the same day, February 26, 2009. One is a gap up and the other is a gap down

The first chart is of a gap up.

Again, the main indicator we are focusing upon is the MACD. So, I have blocked out all of the other indicators so we can focus on this one thing. You can see how BBT gapped up in the middle of the chart. The fast line of the MACD crosses up and through the slower line and accrately mirrors the movement in price. When the price tops out and begins to fall, the MACD correctly mirrors this again as the fast line passes down and through the slow line.

Our second chart was a gap down stock from this same day.

For the chart of PSYS, you can see the MACD formed a confirmed bottom and then the fast line passed up and through the slow line. This would normally be a buy signal. And, if you read a lot of charting books, they will tell you that this is a bullish or buy signal. But, obviously, in this case it is not. The MACD does not accurately mirror the movement in price. The MACD is going up while the prices continue to fall. So, what's up with that?

I will try to explain this without getting too technical. The MACD is comprised of Exponential Moving Averages, rather than Simple Moving Averages. One of the benefits of the EMA is that its complicated mathematical formula accounts for a a longer period of time and gives more weight to recent candles. The problem, however, is that it is more accurate with closer deviations of price, rather than larger deviations.

So, in the case of PSYS above, the stock gapped down by a large amount (about 20%). The result is that it skewed the formula so that when the previous day's prices dropped out of the fast line formula, and the price stayed calm (relative to the previous drop), then the line began to move up even though the price did not.

I hope that makes some sense. Even if it doesn't make sense, then it's still important to remember the end result. The MACD, as a lagging indicator, is not a predictor of price. And, for intraday trades, it can be very slow and even inaccurate when price has moved significantly. Therefore, it is not the first indicator of choice. Nor is it a stand alone indicator for intraday trades.

For myself, it is best to use the MACD as it is intended. It is better at showing larger time window price movements (i.e. daily charts, rather than 5-minute charts). And it is useful in showing a last resort "get out of this trade if you haven't already" when you are deciding whether or not to sell a stock you are holding long. In other words, if the fast line of the MACD crosses down and through the slow line, as it did with BBT, then this is a sure sign that you should get out of this trade. (But, yes, there are exceptions to that rule as well.)

I hope this has helped. It's an important lesson because many traders just blindly follow the MACD in their intraday trading, without recognizing its limitations.

Until next time.