There are other overbought/oversold or momentum type indicators in Technical Analysis (TA), besides the ones I tend to use the most, the RSI and Stochastics. So as to complete my article series, here is another about the MACD indicator. As those of you who peruse my Trader's Corner articles know, I've been writing a series of articles on all things 'technical', from chart analysis and patterns to the various common technical indicators, etc. My goal is to get these foundational articles into our TC archive, for reference by you and by me, when it becomes helpful for me to provide a live link to one of these topics, such as in my weekend Index Wraps.

This series is not all I feel compelled to write about as I also encourage OIN subscribers to e-mail me on OTHER topics of interest pertaining to successful market timing. Technical analysis is ONLY useful in my mind IF it helps spot emerging trends and possible upcoming trend reversals which suggests profitable trades and a profitable year.

Before launching into my technical analysis topic for today, here's my take on the market as of Thursday (10/7/10).

THIS WEEK: MINI TECHNICAL UPDATE

The S&P 500 (SPX) had stalled after retracing 2/3rds or 66% of the April-July decline and I anticipated a dip after the index hit this implied resistance. Commonly, in a strong uptrend, downside corrections will stop at or near the 21-day moving average and it did. This was immediately followed by a decisive upside penetration of what had been fairly tough resistance at 1148-1149. This was the key technical event and better sets the stage for an eventual retest of the prior (April) top. I first envision significant resistance once SPX gets into the 1180-1182 area. It may take awhile to achieve a retest of the 1220 high, especially since SPX is nearing an overbought extreme again.

The recent 'overbought' extreme seen in the back-in-favor tech sectors, in terms of the Relative Strength Index (RSI) and seen on the Nasdaq 100 (NDX) chart below, is not the whole story technically. I've noted the 'congestion' zone as prices have been stalled between 2025-2027 on the upside and 1972-1980 on the downside. This pause of course could be a consolidation of the uptrend and, like SPX did, NDX will blast through the top end of its recent price range. We'll have to see as far as a next breakout. Above this recent trading range, NDX has topped out twice now in the 2055-2060 area; i.e., at 2056 (June 2008) and at 2059, at the April peak.

Another take on the RSI indicator, seen above, is that prices are going sideways whereas (internal) relative strength is falling as measured by the RSI. Such a bearish divergence may or may not be a significant predictor for a pullback in a market that is in a strong advance. This kind of price/RSI divergence does tend to give me pause about getting overly bullish.

MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)

The well known Moving Average Convergence-Divergence indicator, most commonly known as the MACD (pronounced 'mackdee'), is a variation of momentum type indicators, which also purport to show overbought or oversold conditions. Others I haven't written about yet (beside RSI and Stochastics) are Momentum and Rate Of Change (ROC) indicators.

The MACD indicator is calculated by taking the difference between two exponentially smoothed moving averages of closing prices of 12 and 26-day duration; usually these are the only values ever used, although I would just note that Gerald Appel, the market technician who formulated the MACD indicator, suggested that a slightly different set of values ought to be used as a sell 'signal'.

In my opinion, only a 'purist' who relies heavily on this indicator need be concerned about using a variation for this purpose. I have not heard or seen anecdotal or empirical evidence that constructing the slight variation and applying it only in declining trends adds enough value to make it worth the trouble.

The MACD line is the difference between the two averages described, as the longer average (26) is subtracted from the shorter (12). A moving average of 9 periods then is calculated of this differential (the result of the subtraction), which is called the signal line", resulting in a faster moving MACD line. The exponential smoothing technique weights the most recent prices changes more heavily and is therefore quicker to track the latest price changes.

The so-called 'signal' line will be slower because it is a simple moving average of the last 9 values of the differential and is not weighted. There is usually a third line plotted, which is a 'histogram' (these are the vertical bars) used to show the difference above and below a midpoint line of the difference between the MACD line and the signal line. This histogram line is usually included in the standard MACD study to better see the points where there is an upside (the bars go above the midpoint) or downside (bars are below the center or zero line) crossovers.

My first example of the MACD indicator is one applied to the weekly Nasdaq Composite (COMP) chart. There was a 'classic' bullish price/MACD bullish divergence I've highlighted on the chart that suggested a strong buy at COMP's March 2009 low.

I myself usually omit the histogram part of the MACD indicator because I find it 'clutters' up the chart when the size of the chart window is small; the zero line can be seen anyway.

Some past examples of MACD applied to individual stocks shown next are taken from my (Essential Technical Analysis) book:

The reason to include the histogram which isn't seen above but is on my next chart, is that those vertical bars may present a clearer picture of when the difference of the two moving averages is at the widest and narrowest points. However, often it is difficult to see these details given how much is shown on the MACD indicator, which often occupies a small section below a price chart.

It's common as you gain experience, to use indicators with minor modifications such as I describe, but this is an individual thing and relates to how much practice you have or the way in which you use the indicator; e.g., if you use the MACD in order to generate a crossover buy or sell 'signal' only, then the narrowing or widening of the differential is less important.

A common use made of MACD is similar to the crossover technique of other moving averages; i.e., a buy indication or signal is generated when the MACD line crosses above the slower signal line and a sell indication is suggested when the MACD line crosses below the signal line.

MACD use for its potential value in upside or downside 'crossover' buy/sell signals is not unlike the trend following usefulness of moving averages; e.g., where prices cross above or below a single moving average or where shorter and longer averages cross above/below the other. I suggest MACD use on either daily OR weekly charts but tend to favor its use on longer-term weekly charts as a good measure of the momentum of the primary trend. In fact the original use proposed by the person who came up with the MACD model was on weekly charts.

Once there is a weekly chart buy or sell 'signal' and I am not in the market in question yet or want to add to my position, I may take the first MACD crossover signal on the daily chart, that is in the same direction as the weekly signal.

The foregoing is a use of the MACD as a trend following indicator, but I will also focus here on this indicator's use as an overbought/oversold technical model. The way this is done is to define 'overbought' and 'oversold' zones as above or below the zero line respectively. There are times when the two MACD lines are somewhat ABOVE the zero line and have upside crossover type signals. Conversely, there are times that the MACD lines have crossover sell signals BELOW the zero line. In general, these crossovers are not typically the 'best' or strongest signals as highlighted in my next chart below. Some traders also suggest that when BOTH lines cross above or below the zero line, this tends to be a confirmation of the oversold buy or overbought sell 'signals' described.

When the two MACD lines get unusually far above or below the zero lines, this relative position and distance from the midpoint or zero line can in itself be an indication of an overbought or oversold extreme.

With the MACD indicator there is no preset area or position on the right hand (MACD 'reading') scale that suggests that a market is in a definite overbought or oversold zone. In contrast, the RSI has a 'normalized' scale that only goes from zero to 100, with an overbought zone (by convention) that begins at 70; e.g., a reading of 80 to 90 on a 13-day RSI is usually considered very extreme, especially when seen with a major index.

With unbounded indicators like the MACD, that range up or down 'bounded' only by HOW FAR one average moves in relation to the other, it's necessary to look at and rely on past high and low readings (in recent months or years) of the MACD at prior market tops and bottoms as a guide to the current situation in terms of how overbought or oversold the stock or index might be.


GOOD TRADING SUCCESS!