MACD (moving average convergence divergence) and RSI (relative strength indicator) rank among the key stock market indicators that traders use consistently in their analysis.
Now the weekly RSI signal for the S&P 500
is showing less-overbought conditions. After rising above 70 early last week, which was an extremely overbought signal, the weekly RSI is at 56.66 — slightly overbought, but not at the extreme levels of two weeks ago.
When RSI climbed as high as 73 a few weeks ago, it was a huge red flag. Now that RSI is nearer to 50 (i.e., neutral), the S&P 500 could move in either direction. If the index continues to drop this week and RSI falls to near 30, that would signal an extremely oversold market and also a potential buying opportunity.
Weekly MACD signals (for S&P 500)
The weekly MACD line has remained above the zero line, a bullish signal. After Monday’s slide, MACD has moved firmly below its nine-day signal line, a bearish development that reflects the downward shift in momentum. Because MACD is a lagging indicator, it can’t tell us the future, but it does show that in the short term, this bull market is struggling.
Weekly 20-day moving averages (for S&P 500)
Although the 20-day moving average is significant mostly to short-term traders, it is a red flag that the S&P 500 dropped below its 20-day moving average. With the market at a crossroads, savvy traders are on the sidelines with a wait-and-see attitude. No one can predict whether the market will bounce back, or continue to fall.
How RSI works
RSI tells when an index or a stock is overbought or oversold. Like most “bounded” oscillators, it has a reading from 0.0 to 100.0 on the chart.
The purpose of RSI is to let you know if a market or stock is overbought or oversold and may reverse. It doesn’t mean that the security will reverse with 100% certainty, but it does indicate it’s in the danger zone.
How can you identify when a market or stock is overbought? Look at RSI on a weekly (or daily) stock chart. If RSI is 70 or higher, the security is overbought. If RSI falls to 30 or below, it is oversold. It’s really that simple.
When RSI rises to 70 and above
RSI must be 70 or higher and remain above that level to generate an overbought signal. This is a clue that SPX (or another index or stock) is overbought. Hint: Sometimes indexes or stocks will reverse before reaching 70.
As every technician knows, just because a stock or index is overbought doesn’t mean it will reverse immediately. Securities can remain overbought for long time periods before reversing.
When RSI falls to 30 and below
When RSI on the S&P 500 (or an individual stock) falls to 30 or below, and remains under that threshold, that is an oversold signal. It doesn’t mean that SPX will reverse to the upside immediately, but the possibility increases.
How MACD works
MACD, introduced in the late 1970s, is a trend-following momentum indicator. It helps to determine when a trend, and its associated momentum (i.e., directional speed and duration) has ended or begun, or might reverse direction.
Be aware that MACD is a “lagging” or “backward-looking” indicator, which means its signals are delayed, but don’t let that deter you. When MACD yields a signal, it is often significant, especially if used on a weekly chart (versus the daily chart favored by short-term traders).
MACD trading signals
When MACD is viewed on a chart, there are two lines. The black line is referred to as the “MACD line.” The gray (or red) line is referred to as the “signal line.” Remember: the MACD line is the leader line, while the signal line is the laggard line.
In addition, a horizontal line runs across the chart called the “zero line” (0 line). The main function of the zero line is to alert you to the primary trend of the underlying price action.
At its most basic level, MACD generates four signals:
Buy: When the MACD line crosses above the zero line, it’s bullish.
Buy: When the MACD line crosses above the nine-day signal line, it’s bullish.
Sell: When the MACD line crosses below the zero line, it’s bearish.
Sell: When the MACD line crosses below the nine-day signal line, it’s bearish.
Note: When both the MACD line and nine-day signal line move in the same direction (uptrend or downtrend), that is a stronger, more significant signal.
One of the most powerful (but often ignored) additions to the MACD is the MACD-Histogram. It is a separate program that is used to gauge momentum.
The histogram is a series of bar graphs at the bottom of the stock screen. If the bars move above the zero line, it means the underlying stock (or index) is gaining strength, i.e., momentum. If the bars move below the zero line, the stock or index is losing strength.
Many beginning traders don’t realize that momentum always changes before price does. That is what makes MACD and the MACD-Histogram so valuable. Both indicators detect when momentum is weakening. It could also be a signal to become bullish if the histogram bars move above the zero line.
If the MACD-Histogram bar changes to a lighter color, it means that momentum is diminishing. It is not a sell signal; it simply means that enthusiasm for that particular stock is waning.
As mentioned earlier, if the histogram bar rises above the zero line, that is a buy signal. An uptrend may be developing. If the histogram bar drops below the zero line, that is a sell signal. A downtrend may be developing.
Keep in mind that just because MACD generates a buy or sell signal, or that RSI is overbought or oversold, does not mean it is an actionable trade. Like that of any indicator, there are false signals. In addition, it’s essential that you confirm with other indicators before betting real money on a trade.
Michael Sincere is the author of “Understanding Options” and “Understanding Stocks.” He also has a blog, The Weekly Trader (www.michaelsincere.com).