Moving Average Convergence/ Divergence (MACD)

MOVING AVERAGE CONVERGENCE/ DIVERGENCE (MACD)

We mentioned in the previous chapter an oscillator technique that uses 2 exponential moving averages and here it is. The Moving Average Convergence/Divergence indicator, or simply MACD, was developed by Gerald Appel. What makes this indica­tor so useful is that it combines some of the oscillator principles we've already explained with a dual moving average crossover approach. You'll see only two lines on your computer screen although three lines are actually used in its calculation. The faster line (called the MACD line) is the difference between two expo­nentially smoothed moving averages of closing prices (usually the last 12 and 26 days or weeks). The slower line (called the signal line) is usually a 9 period exponentially smoothed average of the MACD line. Appel originally recommended one set of numbers for buy signals and another for sell signals. Most traders, howev­er, utilize the default values of 12, 26, and 9 in all instances. That would include daily and weekly values. (See Figure 10.19a.)

The actual buy and sell signals are given when the two lines cross. A crossing by the faster MACD line above the slower signal line is a buy signal. A crossing by the faster line below the slower is a sell signal. In that sense, MACD resembles a dual mov­ing average crossover method. However, the MACD values also fluctuate above and below a zero line. That's where it begins to resemble an oscillator. An overbought condition is present when

Figure 10.19a The Moving Average Convergence Divergence system shows two lines. A signal is given when the faster MACD line crosses the slower signal line. The arrows show five trading signals on this chart of the Nasdaq Composite Index.

the lines are too far above the zero line. An oversold condition is present when the lines are too far below the zero line. The best buy signals are given when prices are well below the zero line (oversold). Crossings above and below the zero line are another way to generate buy and sell signals respectively, similar to the momentum technique we discussed previously.

Divergences appear between the trend of the MACD lines and the price line. A negative, or bearish, divergence exists when the MACD lines are well above the zero line (overbought) and start to weaken while prices continue to trend higher. That is often a warning of a market top. A positive, or bullish, divergence exists when the MACD lines are well below the zero line (oversold) and start to move up ahead of the price line. That is often an early sign of a market bottom. Simple trendlines can be drawn on the MACD lines to help identify important trend changes. (See Figure 10.19b.)

Figure 10.19b The MACD lines fluctuate around a zero line, giving it the quality of an oscillator. The best buy signals occur below the zero line. The best sell signals come from above. Notice the negative divergence given in October (see down arrow).

MACD HISTOGRAM

We showed you earlier in the chapter how a histogram could be constructed that plots the difference between two moving average lines. Using that same technique, the two MACD lines can be turned into an MACD histogram. The histogram consists of verti­cal bars that show the difference between the two MACD lines. The histogram has a zero line of its own. When the MACD lines are in positive alignment (faster line over the slower), the his­togram is above its zero line. Crossings by the histogram above and below its zero line coincide with actual MACD crossover buy and sell signals.

The real value of the histogram is spotting when the spread between the two lines is widening or narrowing. When the histogram is over its zero line (positive) but starts to fall toward the zero line, the uptrend is weakening. Conversely, when the histogram is below its zero line (negative) and starts to move upward toward the zero line, the downtrend is losing its momentum. Although no actual buy or sell signal is given until the histogram crosses its zero line, the histogram turns provide earlier warnings that the current trend is losing momentum. Turns in the histogram back toward the zero line always precede the actual crossover signals. Histogram turns are best used for spotting early exit signals from existing positions. It's much more dangerous to use the histogram turns as an excuse to initiate new positions against the prevailing trend. (See Figure 10.20a.)

Figure 10.20a The MACD histogram plots the difference between the two MACD lines. Signals are given on the zero line crossings. Notice that the histogram turns earlier than the crossover signals, giving the trader some advanced warning.

COMBINE WEEKLIES AND DAILIES

As with all technical indicators, signals on weekly charts are always more important than those on daily charts. The best way to combine them is to use weekly signals to determine market direction and the daily signals to fine-tune entry and exit points. A daily signal is followed only when it agrees with the weekly signal. Used in that fashion, the weekly signals become trend filters for daily signals. That prevents using daily signals to trade against the prevailing trend. Two crossover systems in which this principle is especially true are MACD and Stochastics. (See Figure 10.20b.)

Figure 10.20b The MACD histogram works well on weekly charts. At the middle peak, the histogram turned down 10 weeks before the sell signal (down arrow). At the two upturns, the histogram turned up 2 and 4 weeks before the buy signals (up arrows).

THE PRINCIPLE OF CONTRARY OPINION IN FUTURES

Oscillator analysis is the study of market extremes. One of the most widely followed theories in measuring those market extremes is the principle of Contrary Opinion. At the beginning of the book, two principal philosophies of market analysis were identified—fundamental and technical analysis. Contrary Opinion, although it is generally listed under the category of technical analysis, is more aptly described as a form of psycho­logical analysis. Contrary Opinion adds the important third dimension to market analysis—the psychological—by determin­ing the degree of bullishness or bearishness among participants in the various financial markets.

The principle of Contrary Opinion holds that when the vast majority of people agree on anything, they are generally wrong. A true contrarian, therefore, will first try to determine what the majority are doing and then will act in the opposite direction.

Humphrey B. Neill, considered the dean of contrary thinking, described his theories in a 1954 book entitled, The Art of Contrary Thinking. Ten years later, in 1964, James H. Sibbet began to apply Neill's principles to commodity futures trading by creating the Market Vane advisory service, which includes the Bullish Consensus numbers (Market Vane, P.O. Box 90490, Pasadena, CA 91109). Each week a poll of market letters is taken to determine the degree of bullishness or bearishness among commodity professionals. The purpose of the poll is to quantify market sentiment into a set of numbers that can be analyzed and used in the market forecasting process. The rationale behind this approach is that most futures traders are influenced to a great extent by market advisory services. By monitoring the views of the professional market letters, therefore, a reasonably accurate gauge of the attitudes of the trading public can be obtained.

Another service that provides an indication of market sen­timent is the "Consensus Index of Bullish Market Opinion," pub­lished by Consensus National Commodity Futures Weekly (Consensus, Inc., 1735 McGee Street, Kansas City, MO 64108). These numbers are published each Friday and use 75% as an over­bought and 25% as an oversold measurement.

Interpreting Bullish Consensus Numbers

Most traders seem to employ a fairly simple method of analyzing these weekly numbers. If the numbers are above 75%, the market is considered to be overbought and means that a top may be near. A reading below 25% is interpreted to warn of an oversold condi­tion and the increased likelihood that a market bottom is near.

Contrary Opinion Measures Remaining Buying or Selling Power

Consider the case of an individual speculator. Assume that spec­ulator reads his or her favorite newsletter and becomes con­vinced that a market is about to move substantially higher. The more bullish the forecast, the more aggressively that trader will approach the market. Once that individual speculator's funds are fully committed to that particular market, however, he or she is overbought—meaning there are no more funds to commit to the market.

Expanding this situation to include all market partici­pants, if 80-90% of market traders are bullish on a market, it is assumed that they have already taken their market positions. Who is left to buy and push the market higher? This then is one of the keys to understanding Contrary Opinion. If the over­whelming sentiment of market traders is on one side of the mar­ket, there simply isn't enough buying or selling pressure left to continue the present trend.

Contrary Opinion Measures Strong Versus Weak Hands

A second feature of this philosophy is its ability to compare strong versus weak hands. Futures trading is a zero sum game. For every long there is also a short. If 80% of the traders are on the long side of a market, then the remaining 20% (who are holding short posi­tions) must be well financed enough to absorb the longs held by the other 80%. The shorts, therefore, must be holding much larg­er positions than the longs (in this case, 4 to 1).

This means further that the shorts must be well capitalized and are considered to be strong hands. The 80%, who are holding much smaller positions per trader, are considered to be weaker hands who will be forced to liquidate those longs on any sudden turn in prices.

Some Additional Features of the Bullish Consensus Numbers

Let's consider a few additional points that should be kept in mind when using these numbers. The norm or equilibrium point is at 55%. This allows for a built-in bullish bias on the part of the gen­eral public. The upper extreme is considered to be 90% and the lower extreme, 20%. Here again, the numbers are shifted upward slightly to allow for the bullish bias.

A contrarian position can usually be considered when the bullish consensus numbers are above 90% or under 20%. Readings over 75% or under 25% are also considered warning zones and suggest that a turn may be near. However, it is general­ly advisable to await a change in the trend of the numbers before taking action against the trend. A change in the direction of the Bullish Consensus numbers, especially if it occurs from one of the danger zones, should be watched closely.

The Importance of Open Interest (Futures)

Open interest also plays a role in the use of Bullish Consensus num­bers. In general, the higher the open interest figures are, the better the chance that the contrarian positions will prove profitable. A contrar­ian position should not be taken, however, while open interest is still increasing. A continued rise in open interest numbers increases the odds that the present trend will continue. Wait for the open interest numbers to begin to flatten out or to decline before taking action.

Study the Commitments of Traders Report to ensure that hedgers hold less than 50% of the open interest. Contrary Opinion works better when most of the open interest is held by speculators, who are considered to be weaker hands. It is not advisable to trade against large hedging interests.

Watch the Market's Reaction to Fundamental News

Watch the market's reaction to fundamental news very closely. The failure of prices to react to bullish news in an overbought area is a clear warning that a turn may be near. The first adverse news is usually enough to quickly push prices in the other direction. Correspondingly, the failure of prices in an oversold area (under 25%) to react to bearish news can be taken as a warning that all the bad news has been fully dis­counted in the current low price. Any bullish news will push prices higher.

Combine Contrarian Opinion with Other Technical Tools

As a general rule, trade in the same direction as the trend of the consensus numbers until an extreme is reached, at which time the numbers should be monitored for a sign of a change in trend. It goes without saying that standard technical analytical tools can and should also be employed to help identify market turns at these critical times. The breaking of support or resistance levels, trendlines, or moving averages can be utilized to help confirm that the trend is in fact turning. Divergences on oscillator charts are especially useful when the Bullish Consensus numbers are overbought or oversold.

INVESTOR SENTIMENT READINGS

Each weekend Barron's includes in its Market Laboratory section a set of numbers under the heading "Investor Sentiment Readings." In that space, four different investor polls are included to gauge the degree of bullishness and bearishness in the stock market. The figures are given for the latest week and the period two and three weeks back for comparison purposes. Here's a random sample of what the latest week's figures might look like. Remember that these numbers are contrary indicators. Too much bullishness is bad. Too much bearishness is good.

INVESTORS INTELLIGENCE NUMBERS

Investors Intelligence (30 Church Street, New Rochelle, NY 10801) takes a weekly poll of investment advisors and produces three numbers—the percent of investment advisors that are bull­ish, those that are bearish, and those that are expecting a market correction. Bullish readings over 55% warn of too much optimism and are potentially negative for the market. Bullish readings below 35% reflect too much pessimism and are considered posi­tive for the market. The correction figure represents advisers who are bullish but expecting short term weakness.

Investors Intelligence also publishes figures each week that measure the number of stocks that are above their 10 and 30 week moving averages. Those numbers can also be used in a contrary fashion. Readings above 70% suggest an overbought stock market. Readings below 30% suggest an oversold market. The 10 week readings are useful for measuring short to intermediate market turns. The 30 week numbers are more useful for measuring major market turns. The actual signal of a potential change in trend takes place when the numbers rise back above 30 or fall back below 70.