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THE OPTIMIZED TRADER


Trading The MACD Histogram, Part II

12/29/06 03:44:33 PM PST
by David Penn

Here's a look at trading histogram divergences and crosses of the zero line, targeting specific entries, and examining exit strategies.

Any trader who likes the idea of getting into a move early probably has a cherished spot in his or her heart for divergences. While some other methods work well for spotting tops and bottoms of trends (for instance, Victor Sperandeo's 2B method, also known as the "Turtle Soup setup," as introduced by trader Larry Connor), most traders rely on divergences between markets and oscillators like the stochastic, the relative strength index (RSI), and the moving average convergence/divergence (MACD) to catch the imbalance that occurs when markets make new extremes and oscillators refuse to confirm them.

DIVERGENCES AND ZERO LINES
To this group we can add the MACD histogram (MACDH). Although I rely more heavily on divergences as revealed by the stochastic (mostly as a matter of habit), the fact remains that the MACD histogram is capable of revealing clear-cut, often powerfully realized positive and negative divergences. Those eager to buy trends just as they appear capable of reversing would do well to consider the MACDH along with whatever other tool they use to spot such divergences between the market and the indicator.

The divergences using the histogram can be even easier to spot than in those indicators and oscillators that use single lines to indicate values. Spotting peaks and troughs among a set of vertical bars (as in the case with histograms) tends to reduce the sizing-up that can occur with the stochastic or the RSI, as well as eliminate that annoyance of trying to determine if a peak in an indicator was actually made. While numerical indicator values definitely makes it easier for a trader to be decisive with regard to the different levels, the clarity of the histogram bars makes the indicator that much easier and quicker to consult on a regular basis. See Figure 1.


FIGURE 1: NASDAQ 100 TRUST SERIES. The positive divergence in the MACD histogram from May to July was an excellent sign to the watchful that the bear market in the NASDAQ 100 that began that spring was coming to an end.

A divergence in the MACD histogram looks just like one with any other indicator or oscillator: the market makes a high (or low) and then goes on to make a further extreme, while the indicator registers either a lower high in the case of a negative divergence or a higher low in the case of a positive divergence. In order to set up the trigger session, I rely on a change in slope on the second peak or trough in the histogram.

In the case of a positive divergence following a downtrend, the pattern representing the change in slope would resemble "P-p-P" on the second, shorter peak, with the second "P" representing the trigger session above which to go long. With regard to a negative divergence following an uptrend, a pattern resembling "m-M-m" would produce a trigger session with the second "m" -- below which to go short.

Although it was not something I traded with much frequency, histogram crosses above and below the zero line (that is, when the histogram switches from positive to negative or vice versa) can also provide powerful signals for traders. While histograms above the zero line are more likely to be overbought (and thus sold) and those under the zero line are more likely to be oversold (and thus bought), there is plenty of room between the time the zero line is crossed and a market becomes so overbought or oversold that a change in trend -- or at least a correction -- becomes necessary. And it is in this area that traders looking to buy a histogram that is moving from negative to positive or sell a histogram that is moving from positive to negative that this particular zero line method operates.

HE HAPPY HISTOGRAM
Essentially, these are all ways of getting into the market. Some of the specifics -- like choosing a specific entry level or price -- will vary from trader to trader. I take half the range of the "trigger day" -- the day or session on which the buy or sell/short signal is issued -- and either add that amount to the high of the trigger day (for longs) or subtract that amount from the low of the trigger day (for shorts). Not only does this give me a specific price to enter, but it also provides a little wiggle room based on the kind of trigger I get. A buy signal on a wide-ranging bar will force me to enter the market at a higher level than a buy signal on a relatively short-ranged bar or candlestick. Others may choose to use a fixed-point amount (15 cents above or below the trigger session's high or low), multiples of the average true range (ATR), or even J. Welles Wilder's "extreme point rule," which states that as soon as the price extreme (the high or the low) of the trigger session is violated, the trade should be initiated.


FIGURE 2: APPLE COMPUTERS. When the MACD histogram crosses from negative to positive as a market is moving up from a pullback in a bullish advance, it often provides an excellent signal for traders to climb on board the renewed trend.

Another small feature that I use with the MACDH trading method is the 50-day exponential moving average (EMA). Every trader has his or her preferred moving average duration and type, and I feel comfortable using the 50-day EMA as a bull/bear line in the sand. By that I mean a histogram buy signal is only valid if it occurs above the 50-day EMA on a closing basis. The session can open below the 50-day EMA, but by the close it must be above that level. Otherwise, the buy signal is ignored. At the same time, I only act on histogram short signals that occur below the 50-day EMA. As you might imagine, the exception to this rule is when dealing with divergences which, almost by definition, will have traders buying below the 50-day EMA and selling above the 50-day EMA.

One last note: The sort of exits most appropriate with MACD histogram trading depend more on the sort of trading, particularly in terms of duration. Although the MACD histogram is a good, all-around entry signal creator, I initially liked the approach as a swing trading tool. This meant relying on shorter-term exit strategies like trailing stops or specific "two up or three down" money management (that is, look to gain two points or lose no more than three).

Oliver Velez of Pristine.com has a trade management approach that I've also found helpful. In his book Tools And Tactics For The Master Day Trader, Velez encourages traders to move stops to breakeven once the trade has gained $1, and then employ trailing and time stops. For divergence trades where a little more leeway is a good thing, chandelier stops may be a good option.

SUGGESTED READING
Achelis, Steven B. [1995]. Technical Analysis From A To Z, Irwin Professional Publishing.
Elder, Alexander [1993]. Trading For A Living, John Wiley & Sons.
Gifford, Elli [1995]. The Investor's Guide To Technical Analysis, Financial Times/Pitman Publishing.
Horner, Raghee [2005]. Forex Trading For Maximum Profit, John Wiley & Sons.
Kahn, Michael [2006]. Technical Analysis: Plain And Simple, Financial Times/Pitman Publishing.
Murphy, John J. 1996]. The Visual Investor, John Wiley & Sons.
Velez, Oliver [2000]. Tools And Tactics For the Master Day Trader, McGraw-Hill.



David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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