How to Use the MACD Indicator to Find Good Trades

01/17/2011 11:14 am EST

Focus:

Corey Rosenbloom

Founder and President, Afraid to Trade

MACD (Moving Average Convergence/Divergence) is a popular technical analysis indicator created by Gerald Appel in the late 1970s. Many traders ask how I use this tool and what my settings are in the software I use.

Let me walk you through a very good recent example of setting up and trading two specific high-probability, low-risk opportunities in the PowerShares US Dollar Index Bullish ETF (UUP). It will serve as a good lesson on how I use MACD combined with price movement to find good trades.

In fact, this type of lesson is just as applicable on any stock or market.

Let’s set the picture up first on the daily chart:

chart
Click to Enlarge

Since December, the dollar index—seen above using the ETF proxy UUP—has been in a sideways trading range with clearly defined price boundaries.

They’re roughly $81 (resistance) and $79 (support) in the dollar index, though that translates to around $23.30 (resistance) and $22.75 (support) in the UUP.

Keep in mind it’s the concept and not the price levels that are important in learning this lesson. The range would be much wider in a more volatile stock or market.

So cutting through all the noise, the main idea as we slip down to the lower frames is that the $23.30/$23.50 level was a key price resistance level to watch as a known reference level (prior low and near the upper Bollinger band).

With this resistance in mind, let’s now step inside the intraday charts to determine where a specific intraday trade entry occurred (one which you could use leverage as necessary to compensate for the low price target 50 cents lower).

Let’s set it up first on the 60-minute chart:

chart
Click to Enlarge

This is a lesson on multi-swing negative momentum divergences, so we use our trusty 3/10 momentum oscillator (change your MACD settings to 3, 10, 0 to replicate this indicator in StockCharts).

As price initially pushed higher near December 21 (first vertical line), we see that a multi-swing negative momentum divergence formed in the oscillator—a great example.

Divergences are non-confirmations that suggest a retracement or reversal in trend is a growing possibility, but only very aggressive traders walk up and put on a trade due solely to a divergence.

I recommend waiting for a signal from price, namely in the form of an official price breakdown of a short-term rising trend line, or under a recent price low, or under a rising short-term moving average (such as the 20 or 50 as seen above).

With that, we have the following information, or wind at our back:

  1. Higher time frame resistance level at $23.30

  2. Multi-swing negative momentum divergence (60-minute)

  3. Price officially breaking the rising 20- and then 50-period EMAs, and of course, rising trend line
So, enter short when price confirms the divergence with a breakdown, such as the $23.20 level as highlighted, or even earlier on a breakdown of the rising trend line (we’ll see that shortly) and 20 EMA at $23.25.

Always place your stop just beyond the recent swing high that locked in the divergence, keeping in mind the higher time frame structure.

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A stop at $23.50 seems logical, which gives a 25-cent stop for about a 50-cent target, namely the prior price swing low as seen from early December. That gives us a two-to-one reward-to-risk relationship (and a generous stop).

In the event you chose to place your stop directly above the swing high at $23.30—let’s say $23.35— then that enhances the reward/risk relationship to a ten- to 15-cent stop (depending on entry) for a five-to-one (risk ten cents to make 50) reward-to-risk relationship.

As you see, the price fell off a cliff and completed a reversal down fully to the target prior price low and actually exceeded it slightly, triggering your profitable exit at or just beyond your target (trust your targets!).

I won’t go into as much detail on the second, roughly identical structural set-up that just triggered and hit its target today.

We had a similar price swing up to the higher time frame resistance, a very similar multi-swing negative divergence, and a very similar structural price breakdown/confirmation, which was actually more violent/rapid than the previous set-up.

This had entry on the gap down yesterday morning at $23.30, same target $22.75, and this trade met its objective even quicker.

Now, let’s take it one step beyond the charts and focus exclusively on price and momentum—and trend lines—to make this set-up even easier to understand and implement.

This is a 30-minute chart of UUP:

chart
Click to Enlarge

Looking just at price, trend lines, and the 3/10 momentum oscillator, you can see the clarified entries—including the recent aftermath of the morning gap the previous day.

It’s a sub-lesson in price reversals after multi-swing divergences—sometimes they can be like breakout trades that don’t give you clean entries, but you have to trust the structure and opportunity, or else you’ll feel you’re chasing the move and miss the opportunity.

Therefore, it’s so important to see many examples like this so that you build your experience and confidence so you can enter, manage, and exit appropriately the next time a similar set-up occurs.

Now one last chart, stepping even closer inside the recent swing, this time using the @DX futures contract:

chart
Click to Enlarge

You’re probably more likely to trade the dollar index via the futures or forex market (relative to other currencies) than the UUP intraday, so I wanted to give that perspective, but still show the UUP for traders who don’t use futures.

Anyway, the recent sell set-up example above in the UUP that was a 50-cent move was roughly a $1.80 index move in the dollar index futures contract (from the $81 level to the $79.20 level), making the profit potential up to $1,800 per single contract, with a risk being the top of the swing high at $81.60 (risking about $600) for a good three-to-one reward-to-risk relationship.

For reference, a ten-cent move in the DX futures contract is $10 for your account per contract. The index moves in half-cent increments, making it a good market for traders who want to learn futures to practice futures trading.

The main idea is that these salient concepts—higher time frame resistance (or support in the opposite case) and lower time frame multi-swing divergences—are powerful combinations that often lead to low-risk, high-probability opportunities in virtually any market and time frame (provided you combine a higher and a lower).

While it’s fun to discuss structure and set-ups, the money is made with execution tactics, and I’ll be doing a presentation soon at the New York Trader’s Expo, February 20-23, where I discuss specifics of “Trade Execution Tactics.”

By Corey Rosenbloom, trader and blogger, AfraidToTrade.com

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