I've reviewed in prior Trader's Corner articles (9/20 & 9/24) 2 of the 3 common technical indicators that measure price momentum
and are also used to suggest points where the stock or index being measured is overbought
. The MACD
indicator is the last of the common 3 such indicators that I'm writing about today. First I'll review the RSI and Stochastics indicators briefly.
The Relative Strength Index or 'RSI':
I myself use the RSI the most of the three. The RSI is a ratio of the average number of points gained for a certain number of trading periods (e.g., hours, days, weeks), which is the RSI length setting, divided by the average point decline for the same number of trading periods or 'bars'. There is a single line only, unlike the two lines of the Slow Stochastics setting, so there is never a buy or sell 'signal' crossover.
I favor the RSI as I'm not 'mislead' so to speak by the RSI showing a buy or sell 'signal'. This because of better-defined 'overbought' or 'oversold' price zones and because of the more precise nature of a ratio as used to show bullish or bearish price/RSI divergences. For more on the RSI and its uses please refer to my 9/20 "Concepts of Overbought/Oversold" article by going to the OIN Home page, clicking on the top 'Trader's Corner' tab and scrolling down.
I'll just further update a couple of interesting RSI/price patterns I've noted on HOURLY charts for the S&P and the Nasdaq 100. Another advantage I've found in using the hourly RSI with a '21' length setting is that resulting key overbought/oversold zones will give me MORE trade ideas.
In a strong bear or bull trend, like the current bull market, there are few 'oversold' readings (e.g., around 30-35) that occur on the daily charts, whereas there are some buy AND sell 'signals' suggested by low or high hourly RSI readings per the below SPX hourly chart seen below; 'extremes' are at 75 and 35.
There are some premature overbought or oversold readings seen on the SPX hourly chart below but the use of a longer-term hourly chart produces some insightful RSI and price patterns. The price patterns seen are the exact 66% or 2/3rds retracement low based on the LAST upswing dating from the early-July bottom. I favor as a general rule buying the fibonacci 61.8 retracements extending to 2/3rds or 66%. The rebound from the 66% retracement was coupled with the strong support seen at the hourly up trendline dating from the early-July lows:
There is another aspect to use of an 'RSI' that I found based on a trading system I devised that uses 'optimized' (for profit) RSI levels of 39 and 72. This trade strategy showed back tested results of 95 winning trades versus 50 losers for the period I've been able to test so far with QQQQ (the NDX tracking stock) dating from late-2003/early-2004. (I'm now starting to save more hourly data.) Moreover, use of the hourly QQQQ chart shows a Head & Shoulder's Bottom pattern that was fully formed recently and 'confirmed' by a neckline breakout:
The Slow Stochastics indicator:
Some traders use this indicator to good effect, more so from what I've seen, in the futures markets. The Stochastics formula measures current prices relative to the highest high and lowest low for some number of trading periods (i.e., the 'length' setting) whether on an intraday, daily or weekly chart. There is 'slowK' line that changes faster rather than a slower 'slowD' line in the Slow Stochastics indicator. This is what gives the bullish/bearish type 'crossover signals'.
Oscillators like Stochastics are 1.) especially useful in terms of timing trades that are consistent with the dominant trend; e.g., buying even minor oversold dips in an overall uptrend, shorting even minor overbought rallies in a dominant downtrend.
Stochastics are next most useful 2.) where an index or stock is experiencing two-sided price swings where highs and lows are made in the same area repeatedly. The stochastic will register overbought or oversold in those areas.
3.) Stochastics work third best to 'time' an intermediate trend reversal occurring within a strong major trend, either up or down. If price action also suggests a possible intermediate trend reversal, than the 'confirming' usefulness of a buy or sell stochastic 'signal' is increased.
More on the Stochastics indicator and its possible uses in trading decisions can be found in my 9/24 Trader's Corner article.
A daily Stochastics indicator is applied to the daily S&P 500 chart below and the last 'signals' so to speak were the downside bearish crossover of 9/23 and the bullish upside crossover of the Tuesday (10/6) close. I haven't done much work on using the Stochastic indicator on hourly charts but this could be a fruitful way to use this indicator also and if you've used it on hourly charts let me know how it has worked for you.
The MACD Indicator:
The well known Moving Average Convergence-Divergence indicator, most commonly known as the MACD ("mack-dee"), is another variation of so-called price oscillators.
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 bearish crossover 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 antidotal 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 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 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 is usually included in the 'standard' MACD indicator 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.
I usually dispense with the histogram because it clutters up the chart when the size of the chart window is small and the zero line can be seen anyway. Two MACD chart examples are shown below starting with this indicator applied to the current weekly S&P 500 (SPX) chart. Other examples are historic ones taken from my (Essential Technical Analysis) book.
A reason to include the histogram is that those bars may present a clearer picture of when the difference of the two moving averages is at the widest and narrowest points. The histogram shows bars above and below the ZERO line. Often however, 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.
Itâ€™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. For example, 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 but the standard use of the histogram is seen below:
The use made of MACD is similar to the crossover technique of other moving averages: 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.
Use in this fashion is not unlike the trend following usefulness of moving averages (one or a set of two moving averages) that define and track the dominant trend, either up or down. 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.
Once there is a weekly chart bullish upside or bearish downside crossover 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 indictor, but we are focused here on its use as an overbought/oversold type oscillator and, as such, we want to employ it for buying when the market we are following is oversold and for a possible long exit or shorting, when the MACD suggests an overbought condition. One 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 crossover signals. Conversely, there are times that the MACD lines have crossover sell signals below the zero line.
However, in general these crossovers not typically the best or 'strongest' signals as seen in the chart below. Some technicians also suggest that when BOTH lines cross above or below the zero line, this is a confirmation of the oversold buy or overbought sell signals described:
You'll notice in the first MACD chart example used, that of the weekly S&P 500 seen above, the bullish upside MACD crossover was WELL BELOW the zero line. This would suggest that the upside bullish crossover 'buy signal' back in March was a 'strong' one. You need only look at the trend since then to confirm this.
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.
However, there is no preset area or position on the right hand MACD scale that suggests that a market is in a definite overbought or oversold zone. The RSI and Stochastic indicators have scales that ONLY go to as high as 100 and overbought zones (by convention) that begin at 70-80; e.g., an RSI reading of 85 or above is very extreme on a 13-day basis.
With 'unbounded' indicators like the MACD oscillator that range up or down bounded only by how far one average moves in relation to the other, itâ€™s necessary to look at and rely on past high and low readings of the MACD at prior market tops and bottoms as a guide to the current situation.
GOOD TRADING SUCCESS!