The MACD Profit Alert

6 Pages·1998·0.389 MB·English

by  Star B.

Stocks & Commodities V16:12 (588-593): The MACD Profit Alert by Barbara Star, Ph.D.
INDICATORS
The MACD THE MACD PROFIT ALERT PATTERN
The assumption underlying the use of the profit alert pattern
is that the trader has already entered a trade. The entry
Profit Alert strategy need not be tied to the MACD; it could be based on
trendline or price breakouts, momentum divergences, mul-
tiple moving averages and so forth. In addition, the assump-
tion is that the trade moves in the desired direction. With these
assumptions in mind, the trader needs some way to protect
profits. At this point, it may be advantageous to use the MACD
profit alert pattern, which warns of a potential change in trend
The moving average convergence/divergence (MACD) is a
and suggests when to take part or all of the profits.
momentum indicator, and here it’s combined with pattern
recognition to help you identify exit points for your trading
The Alert: The MACD profit alert pattern consists of two
system.
major aspects. The first is the alert, which focuses on the
space between the solid line and dotted line. In an upmove,
by Barbara Star, Ph.D. the solid line is above the dotted line. As prices pull back, the
solid line moves down toward the dotted line. At some point,
t takes more than a good entry the solid line pulls back close to the dotted line but does not
strategy to trade profitably. break through; then the solid line rises again as price resumes
Many traders have experienced its trend. The valley or trough left by the solid line pullback
I
the exhilaration of being in a is the profit alert; the first move up of the solid line following
winning trade. Some of those the downturn completes the alert portion of the pattern.
same traders have also known Conversely, in a downward price move, the solid line is
the disappointment of watch- below the dotted line. At some point during the decline, price
ing their profit turn into a loss rallies, causing the solid line to move up toward the dotted
when prices change. Knowing line without breaking through it. Then the solid line moves
when to take profits is part of back down as price resumes its downtrend. The peak or cap
good money management. The moving average conver- produced by the rally attempt and the subsequent downturn is
gence/divergence (MACD) profit alert presented here is a the profit alert; the first downward move of the solid line
pattern that helps traders make profit-taking exit decisions in completes the alert pattern.
both the stock and commodity markets. In the ideal scenario, a cross of the solid line below or
above the dotted line during the pullback or rally negates the
THE VERSATILE MACD profit alert pattern.
Basically, the MACD is a momentum indicator that fluctuates
above and below a zero line. Its developer, Gerald Appel, The Profit-Taking Exit: Traders, of course, are most inter-
presented it as a trading method composed of two compo- ested in the second aspect of the pattern, the profit-taking exit
nents. The first is a solid line that represents the difference (PTX). After the alert occurs during an upmove, take profit the
between two exponentially smoothed moving averages, of- next time that the solid line peaks or caps and turns down.
ten referred to as the MACD line. The second component, the During a downmove following the alert, the profit-taking exit
signal or trigger line, is a dotted line that is an exponentially occurs the next time the solid line forms a valley or trough and
smoothed moving average value of the solid line. (See turns up. The function of the PTX is to preserve profits, not to
sidebar “The MACD.”) The MACD trading method consists of pick exact tops or bottoms; the PTX tends to take place before
buying when the solid line crosses above its signal line and an intermediate top or bottom forms. Obviously, the amount
either exiting and/or short selling when the solid line crosses of profit depends on the entry price, the amount of slippage
below its signal line. on exit, and commission charges. Depending on the money
The original MACD method continues to be a favorite management method used, the trader may wish to take partial
among traders, useful in ways beyond the initial technique. profits at the PTX or cash out completely.
One alternative use is as a gauge of trend when both the solid The chart of Hutchinson Technology (Figure 1) illustrates
and dotted lines remain above the zero line during uptrends the MACD profit alert pattern with both rising and falling price
or below the zero line during downtrends. Another is to action. The alert is marked with an “A” and the point at which
identify divergences between the indicator and price prior to to take profits is labeled “PTX.” The PTX often precedes the
changes in trends. crossing of the MACD solid and dotted lines by a few days.
I have found yet another use for the MACD, that of a profit- Even though profit alert patterns occur on many equities,
taking alert and exit function based on a pattern made by the the profit generated at the PTX is usually greater with stocks
relationship between the solid and dotted lines. that trade above $20. In the healthcare category, Cambridge
Heart (Figure 2) is a good example of a stock that produced
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Stocks & Commodities V16:12 (588-593): The MACD Profit Alert by Barbara Star, Ph.D.
NEY excellent profit alerts yet yielded a loss because it traded in a line for at least 14 price bars prior to the completion of the
HA very narrow price range. profit alert pattern. (See sidebar “The bar count.”) Count the
LISA day that the alert pattern completes itself as zero and then
FILTERING OUT FALSE SIGNALS count back 14 days. If the solid line is above the dotted line
Markets rarely move up or down smoothly. Several pullbacks on the 14th bar, then a potentially valid alert is in place. Fewer
may occur in price advances and rallies in declines, but not all than 10 to 12 bars is not sufficient and usually produces a false
pullbacks are created equal. In this case, not every move of the profit alert signal.
solid line toward the dotted line constitutes a valid profit alert. In a downmove, the solid line must be below its dotted line
False signals occur mainly because there are too few bars prior for 14 price bars or more prior to the completion of the profit
to the alert and/or too much space between the solid line and the alert pattern. Again, fewer than 10 to 12 bars usually produces
dotted line during the pullbacks or rallies. Most of those false a false profit alert signal.
signals can be filtered by using two simple rules: A pullback or rally that penetrates the dotted line negates
the alert. When that happens, the new profit alert would have
Rule 1: In an upmove, the solid line must be above its dotted to complete its pattern at least 14 bars beyond the penetration.
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Stocks & Commodities V16:12 (588-593): The MACD Profit Alert by Barbara Star, Ph.D.
MOVING AVERAGE CONVERGENCE/DIVERGENCE
(MACD) AND MACD HISTOGRAM
The moving average convergence/divergence(MACD) is
an advanced indicator, developed by Gerald Appel, using
two different-length exponential moving averages (EMAs) of
the closing prices of the underlying security. EMAs are used
because unlike simple moving averages, they give greater
significance to more recent prices and are more sensitive to
recent price changes.
The graph of the indicator contains two lines (sidebar
Figure 1). The first line is calculated by subtracting a 26-day
EMA of the closing prices from the 12-day EMA of the closing
prices, and this difference, plotted as a solid line, is known
as the MACD line. The second line, known as the signal line,
is constructed by calculating a nine-day EMA of the MACD
line, and is plotted as a dashed line. Sidebar Figure 2 shows
how the two EMAs of underlying closing prices move relative SIDEBAR FIGURE 1: MACD FOR ABBOTT LABS. The two lines that make up the
to the underlying. MACD are shown above. The solid line is the result of subtracting the 26-day EMA
A buy signal occurs when the MACD line crosses above from the 12-day EMA, and is called the fast MACD line. The dashed line is the
the signal line, and the sell signal is the MACD line dropping nine-day EMA of the MACD line and is called the slow signal line.
below the signal line.
The MACD histogram, a variation of the MACD, is con-
structed by plotting the difference between the MACD line market. When the slope changes from positive to negative,
and the signal line as a series of vertical bars. The vertical long positions are closed and short positions are estab-
difference above and below the zero line represents the lished. Conversely, when the slope changes from negative
difference between the MACD and its signal line (sidebar to positive, shorts are covered and longs are established.
Figure 3). The bars will be above the zero line if the MACD —Stuart Evens
line is above the signal line, and the bars will be below the
zero line when the lines have switched places. A value of
zero in the histogram corresponds to the intersection of the
two lines.
The slope of the MACD histogram is determined by mea-
suring the slope of a line connecting two neighboring bars.
Changes in slope of the MACD histogram can be used to
signal entry and exit points when trading the underlying
SIDEBAR FIGURE 2: ABBOTT LABS. Here, we see the 12-day moving average SIDEBAR FIGURE 3: COMPARISON OF MACD AND MACD HISTOGRAM. This
responding faster to price movement than the 26-day moving average. The comparison shows the correlation between the two indicators. The amount of
difference of these two lines results in the solid MACD line. separation between the two lines determines the size of the bars. Which line is
above the other determines which side of the zero line the bars will be on: above
when the signal line is above the MACD line, and below when the two lines are
reversed.
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Stocks & Commodities V16:12 (588-593): The MACD Profit Alert by Barbara Star, Ph.D.
US
OTES PL PTX
QU A A A
DATA BY A PTX
NAL), PTX
O
NATI PTX A
NTER A
UIS I A
CK (EQ A PTX PTX
O
METAST FIGURE 1: HUTCHINSON. The alert in April at point A began as the MACD solid line FIGURE 2: CAMBRIDGE HEART. Even though the alerts worked well with Cam-
dipped toward the dotted line without penetrating it. The alert completed itself on the bridge Heart, the total price range was too small to make a profit. Stocks that trade
close of April 13, 1998, the day after the solid line had bottomed and began to move above $20 usually produce better profits.
higher. The signal to take full or partial profits occurred on April 22, 1998, the first
time that the solid line closed down to form the profit-taking exit (PTX). During the
May-June downmove, an alert was completed on June 10, 1998 (point A), after the
solid line had been below the dotted line, moved up toward the dotted line, and then
turned down. The PTX signal took place on June 19 as price was beginning a
False Alert
countertrend rally. PTX
A
False Alert
PTX
The pattern on the Boeing stock chart in Figure 3 shows
such false alerts during both the December–January False Alert PTX
downmove and the February–March upmove. In the Decem- A
ber 1997–January 1998 downmove, the first rally in Decem- A
ber seemed like a potential alert. However, it did not qualify
PTX False Alert
because the alert completed itself in only 10 price bars. The
valid alert occurred on January 6, 1998, and the PTX signal FIGURE 3: BOEING. Boeing illustrates both false and valid alerts. The December
registered on January 22, 1998. 1997 move of the solid line toward the dotted produced a false alert because there
were fewer than 10 price bars at the conclusion of the potential alert. The valid alert
During the January–February 1998 upmove, the initial
did not take place until January 1998. The February 10th alert proved false because
February pullback took place fewer than 10 price bars after it violated both rules 1 and 2.
the rise of the solid line above the dotted line. The valid
THE BAR COUNT
The chart of Hutchinson seen in sidebar Figure 4 demon-
strates how to verify the bar count suggested in rule 1. The
profit alert pattern completes itself after the solid line has:
14 1312 11 10 9 8 7 6 5 4 3 2 1 0
1 Been above/below the dotted line for 14 bars or more
2 Moved toward the dotted line
3 Resumed its original up or down direction.
14 Bars
During a pullback in an upmove, the alert pattern is com-
plete the first time the solid line forms the valley with an
increasing numeric value. In this example, the numeric
value of the solid line began its decline on April 6, 1998, with
a numeric value of 1.06, down from the 1.09 value the 14 Bars
previous trading day.
The numeric value of the solid line continued to decline
SIDEBAR FIGURE 4: HUTCHINSON
until it reached its ebb on April 9, 1998, at a value of 0.85.
The next trading day (April 13, 1998), the solid line recorded of 14 bars or more above the dotted line suggests a poten-
a value of 0.89, the first upward numeric value since the tially valid alert. The next downmove of the numeric value of
decline began. The histogram at the top of the chart depicts the solid line represents the point at which to take full or
the decline and registers its shortest bar on April 9, 1998. partial profits.
The next histogram bar is higher than the bar on April 9 and In a downmove, the reverse is true. The alert pattern is
verifies the solid line value, which signals the completion of complete when the solid line has been below the dotted line
the alert pattern. That first higher bar (on April 13, 1998) is for 14 bars, has rallied up to the dotted line, peaked and
the zero point and the place to begin the bar count. A count resumed its original up or down direction. —BTS
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Stocks & Commodities V16:12 (588-593): The MACD Profit Alert by Barbara Star, Ph.D.
0.02 A
0.03 A
False Alert
A
PTX
False Alert
False Alert A
A
False Alert
FIGURE 4: BOEING. The MACD histogram helps verify a bar count and clearly FIGURE 5: JUNE 1998 US DOLLAR. In addition to a valid bar count as specified
shows when the solid MACD line enters positive or negative territory. The histogram in rule 1, the ideal profit alert pattern also shows a shortening of the histogram bars
bars made it easy to count backward from the potential alert on December 19, 1997, within the parameters discussed in rule 2 during pullbacks and rallies. The June US
and realize it was a false alert because it was only seven bars from the completion dollar illustrates both rules. The histogram bar contracted to 0.02 on April 30, 1998,
of the alert to the time the histogram went above its zero line. The histogram also plus it had a bar count greater than 14 on May 1, the day of the alert. And at the solid
helped identify the false alert on February 10, 1998, that completed in only 10 bars. line pullback in June, the histogram bar contracted to 0.03 the day before the solid
line began to rise. This created a valid alert on June 5. The earlier pullback in May
met the criteria for rule 2, but did not meet the bar count needed to satisfy rule 1.
pullback alert completed on February 25, 1998, and a PTX its zero line, the solid line is above the dotted line; when the
was given on March 3, 1998. histogram is below its zero line, then the solid line is below the
dotted line. The histogram makes it easier to verify the 14 or
MACD HISTOGRAM HELPS CONFIRM AN ALERT more price bar count preceding the end of the alert pattern.
The MACD histogram is the name given to the difference in Look at the Boeing stock again, this time in Figure 4 with
value between the solid line and the dotted line. It is created the histogram added. It verifies not only the bar count, but
by subtracting the numeric value of the dotted line from the shows when the solid line moves above or below the dotted
numeric value of the solid line. This represents the space line and whether the solid line penetrated the dotted line
between the solid and dotted lines and takes the shape of an during the pullbacks or rallies.
oscillator that moves above and below a zero line. The zero Rule 2: Once a bar count of 14 or more has been confirmed,
line denotes the point at which the solid and dotted lines of the check the numeric value of the histogram to determine the
MACD indicator cross. extent of the move toward the dotted line. The histogram bars
By changing the oscillator line–style from a solid to a histo- contract as the space between the solid and dotted lines
gram, it becomes easy to discern when the solid MACD line goes decrease. Ideally, during pullback/rally alerts, the histogram
positive or negative. When the bars of the histogram are above maintains a numeric value bounded by +0.01 and +0.15
above its zero line, or -0.01 and -0.15 below its zero line.
The daily price chart of the June 1998 US dollar contract
illustrates a valid histogram contraction during the alert (Fig-
PTX ure 5). The histogram bars were shortened to -0.02 in the April–
A May solid line countertrend rally alert. Although the histogram
decreased in value to an acceptable alert level in the May
pullback, the bar count was less than 14. The pullback in June,
however, met the criteria for both the bar count and the amount
of histogram contraction to produce a valid alert.
PTX Remember to use the MACD numeric values rather than the
histogram values to determine turning points at the alerts and
A
PTX to avoid a different type of false signal.
VARIATIONS FOR THE BRAVE OF HEART
The alert and profit-taking patterns shown thus far are based
on ideal formations. Even though the ideal occurs often
FIGURE 6: DAYTON HUDSON. When the solid and dotted lines merge after a valid enough to make it worthwhile to check for the pattern, a few
bar count, the trade becomes more risky. Often, prices continue in the desired
variations pop up but are riskier to trade. For example, some-
direction, but just as easily, they can go the opposite way. The first downmove of
the solid line that formed a PTX occurred on March 30, 1998. times the solid line merges with the dotted line during an alert
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Stocks & Commodities V16:12 (588-593): The MACD Profit Alert by Barbara Star, Ph.D.
instead of approaching the dotted line and then moving away,
as the ideal requires (Figure 6). Sometimes this will resolve
PTX
itself and the line will continue in the desired direction. On
occasion, however, it may also serve as a precipice from which
A
prices bounce or plunge in the undesired direction.
Another variation occurs when the solid line dips briefly
PTX
below the dotted line. Many times, the penetration of the A
dotted line is short-lived and prices turn around, as they did
with the June 1998 S&P 500 contract (Figure 7). The solid
line pulled back and penetrated the dotted line on March 5,
1998, which should have negated the alert. But the next day, PTX
A
the MACD numeric value increased, as did price. The solid
line and price continued to rise, even though the histogram
remained below its zero line.
FIGURE 7: JUNE 1998 S&P 500. Here, the solid line dips below the dotted line in
So follow the histogram or follow the solid line? In this
March, which generally negates the alert. However, both the solid line and price began
case, the solid line proved to be the better choice, as the rising within a day following the break, even though the histogram remained below its
histogram confirmed on March 11. The PTX took effect zero line. The risk is that price could fall rather than continue its upward bias.
approximately two weeks later at a much higher closing
price. Risky? You bet! It is best to be cautious with this
pattern variation. RELATED READING
Appel, Gerald [1985]. The Moving Average Convergence-
OBSERVATIONS Divergence Trading Method, Advanced Version, Scientific
The MACD profit alert offers the advantage of easy pattern Investment Systems.
recognition that warns of impending changes several days in Ehlers, John [1991]. “The MACD indicator revisited,” Technical
advance, and the alert can be combined with other stop-loss Analysis of STOCKS & COMMODITIES, Volume 9: October.
methods. The disadvantage? Some very nice price moves Hartle, Thom [1991]. “Moving average convergence/diver-
may not produce any profit alert patterns. gence (MACD),” Technical Analysis of STOCKS & COM-
It is best to resist the temptation to use the MACD signal line MODITIES, Volume 9: March.
for entries to the up- or downside once a PTX takes place. Too Star, Barbara [1994]. “The MACD momentum oscillator,” Tech-
often, price goes sideways, which can cause the MACD to nical Analysis of STOCKS & COMMODITIES, Volume 12:
whipsaw and erode the profits already taken. In the same February.
vein, be cautious about entering a trade at the alert, as
†See Traders’ Glossary for definition S&C
continuation moves often can be short-lived.
Many traders will look at these charts and see that the alert
pattern usually ends several days from the actual price top or
bottom, and they may want to stay in the trade longer. If so,
at least take partial profits at the PTX. When using a profit
protection strategy, it is better to be early than late. The whole
point is to have enough equity to trade again another day.
Barbara Star, who is a university professor and part-time
trader, provides individual instruction and consultation to
those interested in technical analysis. She leads a MetaStock
users’ group and is a past vice president of the Market
Analysts of Southern California. Price data courtesy of
Quotes Plus, Ortonville, MI.
Copyright (c) Technical Analysis Inc. 6