Post by TradingForGod on Aug 18, 2004 10:23:13 GMT -5
This is the last in our series on the fundamentals of technical analysis. We have previously discussed the early development of the “art” (candlestick charting), pattern recognition (Elliott Wave), the mystery of Fibonacci numbers, determining trending and non-trending markets and a few ideas for how to trade them, and how to identify and trading congesting markets. Today we’ll focus on a couple of momentum indicators that help to refine entry and exit points. I use the Moving Average Convergence/Divergence (MACD) and the Slow Stochastics (SSto).
The MACD indicator, developed by Gerald Appel, measures the relative strength or weakness of a market by comparing the difference between two moving averages of different lengths with the recent average of those differences. Most software packages subtract the 12 period MA from the 26 period MA and then compare that value to the average of the last 9 observations. This “average of the averages” is referred to as the Signal Line. Let’s assume the market is bullish. The theory is that as prices rise the shorter term MA will rise faster than the longer term MA. In other words the MAs will “diverge”. As this difference gets larger it moves away from the average of the differences too. It’s sort of like watching your cars speedometer. If you are driving at a constant rate of speed the car is moving, but the speedometer stays in one place. But if you press down on the accelerator, not only are you moving but you begin moving faster. The MACD works the same way. Theoretically, if the market is rising at a constant rate over a long period of time, the distance between the MAs will stay constant and the average of the differences will be constant too. So the MACD would read zero even though the market is still moving high. It is just not ACCELERATING higher. I hope that makes sense. When prices begin to stall out, the shorter term MA begins to flatten out faster than the longer term MA does, so they begin to “converge”. As this happens the difference between the current difference and the Signal Line starts to fall. Basically the market is decelerating, kind of like the way a car does as you move toward a traffic light. You are still moving forward (prices still rising), but you have the foot on the brakes.
In the literature about this indicator it talks about buying the market when the current difference crosses the Signal Line and selling when it crosses below that. Personally I have never found that to work. Unless the market is in a MEGA trend, you end up buying too late in the trend and selling out well after the trend has peaked. I have come to use the MACD primarily as an early warning indicator to alert me to possible reversals. Let’s think about the car example again. Have you ever seen a car go from 55 MPH into reverse? No, because it would tear the transmission apart. The car has to stop before it can reverse. And is has to slow down (decelerate) before it can stop. SO, I look for times when prices are still rallying but the MACD is falling to alert me to potential trend reversals. These are called “momentum divergences”, and as time goes on you will see me mention them a lot. They can be extremely powerful reversal indicators that can save you lots of money by getting you out of trades much closer to the top. However, the fact that prices are making new highs on lower momentum doesn’t necessarily mean the market is about to reverse. It just means it could reverse. It’s like a tornado watch alert. It doesn’t mean that a tornado is out there, just that conditions are favorable for one.
The second indicator I use as a momentum oscillator is the SSto. This indicator, developed by George Lane, measures the relative strength or weakness of the market in a much different way. The math is pretty complicated, but basically it compares the difference between the closing price and the low of a bar with the difference between the high and low of the bar. In theory, when the market is moving up, the close will generally be high in the range of trading activity of the day. The market generally finishes near the high. In downtrends, the reverse is true. The SSto makes use of this fact and calculates a running average of these differences. The higher recent closes are relative to the recent ranges, the higher the SSto indicator lines. There are two indicator lines called %K and %D. The %D line is just a moving average of the %K line. They both range between 0 and 100.
The conventional trading strategy for SSto is to sell the market when it gets “overbought” (lines above 80) and buy the market when it gets “oversold” (lines below 20). This strategy DOES NOT WORK. Every study I have seen for stochastics alone show that this is a loser. The main reason is that when the market is trending the SSto can be overbought or oversold for a long time. You can get run over trying to catch the turn. I use stochastics as a confirming indicator for trades I am otherwise considering. For instance, let’s say I want to buy a dip after a big rally. I will wait for the stochastics to begin to turn higher from the “oversold” area to take the trade. When combined with other indicators, SSto can really help in timing trades more effectively. In addition, like the MACD, it can also be used to look for momentum divergences to signal trend reversals.
The MSFT chart below shows the MACD (yellow histogram in the middle) and the SSto (at the bottom). You can clearly see how they oscillate with the ups and downs of price. The main thing I want to point out is the huge momentum divergence around the mid-July high. As I said earlier, all that traders would have been able to see at that time was a potential reversal warning. But as it turned out, in this particular case there really was a tornado outside.
So that’s it. That’s most of what I use in my technical assessments. I do some additional pattern recognition work (bull flags, pennants, etc) and some trailing stop criteria, but we will talk about that as we go along. Starting tomorrow, I will be doing periodic technical updates about the stock market and any other things that look interesting. I am open to your thoughts and suggestions about topics to pursue. I look forward to hearing from you.
Read Eccl. 2:26. May we all be men and women who please God.
Blessings,
TFG
The MACD indicator, developed by Gerald Appel, measures the relative strength or weakness of a market by comparing the difference between two moving averages of different lengths with the recent average of those differences. Most software packages subtract the 12 period MA from the 26 period MA and then compare that value to the average of the last 9 observations. This “average of the averages” is referred to as the Signal Line. Let’s assume the market is bullish. The theory is that as prices rise the shorter term MA will rise faster than the longer term MA. In other words the MAs will “diverge”. As this difference gets larger it moves away from the average of the differences too. It’s sort of like watching your cars speedometer. If you are driving at a constant rate of speed the car is moving, but the speedometer stays in one place. But if you press down on the accelerator, not only are you moving but you begin moving faster. The MACD works the same way. Theoretically, if the market is rising at a constant rate over a long period of time, the distance between the MAs will stay constant and the average of the differences will be constant too. So the MACD would read zero even though the market is still moving high. It is just not ACCELERATING higher. I hope that makes sense. When prices begin to stall out, the shorter term MA begins to flatten out faster than the longer term MA does, so they begin to “converge”. As this happens the difference between the current difference and the Signal Line starts to fall. Basically the market is decelerating, kind of like the way a car does as you move toward a traffic light. You are still moving forward (prices still rising), but you have the foot on the brakes.
In the literature about this indicator it talks about buying the market when the current difference crosses the Signal Line and selling when it crosses below that. Personally I have never found that to work. Unless the market is in a MEGA trend, you end up buying too late in the trend and selling out well after the trend has peaked. I have come to use the MACD primarily as an early warning indicator to alert me to possible reversals. Let’s think about the car example again. Have you ever seen a car go from 55 MPH into reverse? No, because it would tear the transmission apart. The car has to stop before it can reverse. And is has to slow down (decelerate) before it can stop. SO, I look for times when prices are still rallying but the MACD is falling to alert me to potential trend reversals. These are called “momentum divergences”, and as time goes on you will see me mention them a lot. They can be extremely powerful reversal indicators that can save you lots of money by getting you out of trades much closer to the top. However, the fact that prices are making new highs on lower momentum doesn’t necessarily mean the market is about to reverse. It just means it could reverse. It’s like a tornado watch alert. It doesn’t mean that a tornado is out there, just that conditions are favorable for one.
The second indicator I use as a momentum oscillator is the SSto. This indicator, developed by George Lane, measures the relative strength or weakness of the market in a much different way. The math is pretty complicated, but basically it compares the difference between the closing price and the low of a bar with the difference between the high and low of the bar. In theory, when the market is moving up, the close will generally be high in the range of trading activity of the day. The market generally finishes near the high. In downtrends, the reverse is true. The SSto makes use of this fact and calculates a running average of these differences. The higher recent closes are relative to the recent ranges, the higher the SSto indicator lines. There are two indicator lines called %K and %D. The %D line is just a moving average of the %K line. They both range between 0 and 100.
The conventional trading strategy for SSto is to sell the market when it gets “overbought” (lines above 80) and buy the market when it gets “oversold” (lines below 20). This strategy DOES NOT WORK. Every study I have seen for stochastics alone show that this is a loser. The main reason is that when the market is trending the SSto can be overbought or oversold for a long time. You can get run over trying to catch the turn. I use stochastics as a confirming indicator for trades I am otherwise considering. For instance, let’s say I want to buy a dip after a big rally. I will wait for the stochastics to begin to turn higher from the “oversold” area to take the trade. When combined with other indicators, SSto can really help in timing trades more effectively. In addition, like the MACD, it can also be used to look for momentum divergences to signal trend reversals.
The MSFT chart below shows the MACD (yellow histogram in the middle) and the SSto (at the bottom). You can clearly see how they oscillate with the ups and downs of price. The main thing I want to point out is the huge momentum divergence around the mid-July high. As I said earlier, all that traders would have been able to see at that time was a potential reversal warning. But as it turned out, in this particular case there really was a tornado outside.
So that’s it. That’s most of what I use in my technical assessments. I do some additional pattern recognition work (bull flags, pennants, etc) and some trailing stop criteria, but we will talk about that as we go along. Starting tomorrow, I will be doing periodic technical updates about the stock market and any other things that look interesting. I am open to your thoughts and suggestions about topics to pursue. I look forward to hearing from you.
Read Eccl. 2:26. May we all be men and women who please God.
Blessings,
TFG
