When viewed on daily or weekly charts, moving averages are at best a secondary indicator when assessing the overall trend strength of a security. For the intraday charting used in day trading, the oscillators we will discuss next are better at showing moving average divergence.
As with the golden and dead crosses, a shorter-term moving average crossing over a longer-term moving average can generate buy and sell signals. This crossing process is called divergence, because the short-term and long-term moving averages diverge from a common point. When you are looking at intraday charts and using tools to make day-trading decisions, the speed at which you can assimilate information is critical. Using an oscillator can be beneficial in identifying moving averages that cross over, and telling when the short-term average extends too far from the long-term one.
The simplest oscillator approach that utilizes these principles is a line that graphs the difference in value between a long-term and short-term moving average, as illustrated in the below figure.
Gerald Appel of Signalert Corporation has refined this method into a more useful oscillator, which is called the Moving Average Convergence Divergence (MACD) method. What MACD does is produce two exponentially smoothed moving averages of the difference between a short-term and a long-term moving average of the price action in a security. This may seem strange at first, since we are going from two moving averages to a single value and then creating two moving averages from it. You might wonder what has been gained. The below figure shows a daily chart of Microsoft as an example. The moving averages on the chart are set to 13 and 34, which give a confirmed buy signal on 6/18 and sell signals on 4/28 and 8/03. The MACD oscillator, however, gave signals for the same moves much earlier: on 5/26 for the buy signal when the faster line crosses above the slower line, and on 4/01 and 7/21 for the sell signals when the faster line crosses below the slower line. So what you are getting is an earlier notification of a divergence in shorter-term and longer-term averages. I chose the Microsoft daily chart at random. You will find that this setup works for just about any actively traded security you choose on a daily chart. This indicator is less useful on intraday charts; therefore I tend to use it more for assessing the overall trend direction of the security than making actual day-trading decisions.
Let's review the signals that these basic types of oscillators give before moving on to two oscillators that you may want to use in intraday charting as secondary indicators.
My advice is always this: Never use just an oscillator to generate a trading decision; use them only to confirm decisions once you understand the trend or trading range of the security being studied. The key to success in technical trading is to use the right tool at the right time, and you can only select the right tool if you understand the basics of trending and can decide which tool is appropriate for range-bound securities, those in a trend, or those attempting to reverse trend.
