Stock Diamond - Technical Analysis Education

Please note that we have used historical data. These examples are for educational purposes only.

Welcome to the 2nd issue of the ChartFilter.com monthly newsletter. This newsletter is designed to provide you with tools you can use every day to make profitable investment decisions.

In each issue we'll focus on the use of a different technical indicator in real-life markets. This month we'll focus on the use of the MACD (Moving Average Convergence/Divergence) technical indicator.

CURRENT TRENDS - Learning from the NASDAQ

In the premiere ChartFilter.com newsletter we looked at the NASDAQ composite index using trendlines and moving averages. At that time the 200-day MA was offering support. I wrote, "if the Index once again breaks down through the 200-day MA we have a further deterioration of the long-term picture for the NASDAQ and a definite sign of weakening markets."

Here's the current picture using Moving Averages:

• The 50-day MA has not been able rise above the 200-day MA.
• The Index has broken down through both 50-day and 200-day MA.

Based on this, the picture for technical stocks on the NASDAQ continues to look very weak for the coming months.

This month in ChartFilter.com I'd like to focus on the use of MACD. Let's look at the NASDAQ using MACD:

The lower chart is the MACD indicator; combining the [href="/?p=Technical-Analysis.Indicators-Oscillators&t=MACD"]MACD oscillator[/HREF] and [href="/?p=Technical-Analysis.Indicators-Oscillators&t=MACD+Histogram"]MACD histogram[/HREF]. The black line is the MACD line and the red line is the signal line. Signals are produced when these lines cross one another as well as when they cross through the Zero line.

From this chart of the NASDAQ with its MACD we can make the following observations:

• The MACD line crossed down through its signal line in mid-July (also shown by the histogram crossing down below zero).
• The MACD line has just crossed down through zero for the second time this year (roughly at the same time as it broke down through the 200-day MA).

These signals can both be taken as signs of weakness in the NASDAQ. If this chart represented a single stock (or an Index fund tied to the NASDAQ) it would be a signal to sell.

Confirmation

Note how the MACD offers confirmation of the signals provided by the Moving Averages, with one often leading the other. Confirmation by several indicators is one of the most important tools available to the technical analyst. The trick is to use indicators that are complimentary, and don't rely on exactly the same set of data (i.e., price and volume data vs price alone). In this case the MACD and MAs are too closely related to be of real benefit; they are basically telling us the same thing represented in different ways. The concept is an important one to keep in mind, though.

The MACD method is a trending indicator, telling us whether a stock is in an uptrend or a downtrend. The MACD proves most effective in trending markets rather than choppy, sideways markets. There are two main sets of signals generated by the MACD: crossovers and divergences.

The MACD Oscillator is composed of two lines: the MACD line, which is the difference between two exponential moving averages (EMAs) and a signal line, which is an EMA of the MACD line itself. The signal or trigger line is plotted on top of the MACD to show buy/sell opportunities. Typically, MACD uses a 26-day and 12-day EMA, based on the daily close, and a 9-day EMA for the signal line.

PROFIT POTENTIAL - Johnson & Johnson Inc

Let's take a look at a real-life example; using MACD with Johnson & Johnson Inc. on the NYSE.

The first task, if you are looking for mid-long term moves as I am, is to determine the long term trend and to trade only in the direction of that trend (buy in an uptrending market). If you used this system you would ignore buy signals offered in a long-term downtrend. From this chart we can see that the trend reversal occurred in March-April, depending on how you went about determining it.

Using the MACD Histogram

If you went by the first trendline break at Pt. A, you might have purchased shortly thereafter, given the buy signal from the MACD-Histogram. (The red and green arrows indicate the buy and sell signals offered by the MACD Histogram.)

Starting at Pt. A there were 4 Buy signals and 3 Sell signals offered by the MACD Histogram exclusive of other indicators. If you had responded accordingly your profit/loss would have looked something like this (excluding commissions): Per Share Purchase Price Selling Price Profit/(Loss) % Change 75.00 71.00 (4.00) - 5.3% 76.00 87.00 11.00 + 14.5% 90.00 93.00 3.00 + 3.2 Total 10.00 12.3%

The total for the three trades would have been about $10.00 profit per share or 12% return on investment, over a period of about five months.

Using the MACD Oscillator plus MAs

A better approach to my mind, however, would have been to consider the 20-day and 50-day MAs -- we can see that these MAs have proven very helpful in providing signals in this particular market -- combined with the MACD Oscillator.

At Pt. B, the 20-day MA crossed upwards through the 50-day MA at roughly the same time as the long-term trendline was broken. This provided a significant indication that the market had indeed reversed trend, particularly when you look at the classic double bottom pattern (see the ChartFilter report on Patterns - Tops and Bottoms for further info.) This would have kept us out of the stressful, choppy price movements during March and the first part of April (choppy markets are a good way to lose sleep as well as capital).

Furthermore, the MACD Oscillator crossed up through its zero line at roughly the same time (indicated by the blue arrow). Using this as a buy signal we could have entered a profitable trade over the past three months or so. The MACD-O has not yet offered a strong exit signal, however, it did dip below the zero line momentarily (second blue arrow). Normally you would wait for both the MACD line and its signal line to penetrate zero; however, if we wanted to lock-in profits, this would have been an opportune time, given that the long term up trend line has also been broken (Pt. C).

The profit on this single trade would have been roughly the same as the three trades based on the Histogram put together (once again excluding commissions). Per Share Purchase Price Selling Price Profit/(Loss) % Change Total 82.00 92.00 10.00 12.2%

What next?

• The 20-day MA is still above the 50-day, so the up trend may continue.
• The last green arrow from the MACD Histogram may be indicating a buy signal.
• The MACD Oscillator has not offered a strong sell signal.
• However the well-established upward trendline has been broken.

To me, this indicates a weakening up trend, and the market is either preparing to form a peak or it's going to go into a sideways, congestive phase before continuing upwards. The $90.00 level is currently providing support (horizontal blue line) so you would want to exit this market if it broke down below that level.