Technical Training Series: MACD Indicator

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK (The FRED Report) -- We have often been asked why we do not use the MACD indicator more in our analysis, and instead use the stochastic oscillator.

One reason for this question is that the MACD indicator appears on the default chart of most of the software packages. The other is that the stochastic is an older indicator, and not as widely understood. In order to fully understand my rationale for this we first need to discuss some features of oscillators and also some definitions.

First, there are two key types of oscillator. One is bounded, and the other is unbounded. A bounded oscillator generally moves between two points, most often "0" and "100". The Stochastic is a bounded oscillator, and another example of a bounded oscillator is Welles Wilder's RSI. The MACD is an unbounded oscillator, which means the rank can keep moving in a direction for as long as a trend lasts.

Let's look at the MACD indicator. MACD stands for Moving Average Convergence Divergence. This means that essentially the indicator measures the difference between moving averages. This is interesting because most people use this indicator as an overbought/oversold indicator when it is actually more of an indicator for strength of trend.

This is one of the main problems with the indicator for me, and I prefer to look at the moving averages themselves to evaluate trend strength. Look at the chart of the SPY with our 5- and 20-day moving averages, and the MACD (created with the 5- and 20-period averages) below. You can see how the MACD has crossed negative while the moving averages themselves have stayed positive. This is another problem with the indicator--- the mathematics of the indicator can cause it to give a signal when, in my opinion, none should be given.

Now, let's discuss the Stochastic. At The FRED Report, we use the Stochastic to find buy and sell points in the trend, or alternatively to identify areas of risk and reward within the trend. This indicator is a pure overbought/oversold indicator. There are two lines that comprise the indicator -- %K and %D.

One of the reasons this is my favorite of the standard overbought/oversold indicators is that %K is derived from an equation that analyzes the whole trading range of the look-back period. Most indicators, including the MACD, only look at the closing price, and I believe that analyzing the entire trading range of prices is important, especially during periods of volatility.