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MARKET UPDATE


MACD Divergences And Market Direction

06/21/07 11:24:23 AM PST
by Jack Steiman

Learn what divergences in the moving average convergence/divergence (MACD) can tell you about which way the market is going.

Technicians use an array of technical tools to help them make decisions about why the market is doing what it is doing and what they think the market will do next. They will run down a list of methods and indicators all the way from Elliott wave to stochastics and be able to make a case for each and every one of those methods and indicators.

APPLYING INDICATORS
There is no question that everything has its place. All of these approaches are usable and quite valuable. However, when talking to folks who take my seminar, they tell me how they'd love to apply what they hear from other traders, but they just can't seem to understand what it is they're looking for when dealing with a particular technical indicator or method. When they hear about stochastics or relative strength index (RSI), it all sounds great. But what they want to know is: How do I apply it? An indicator or trading method may sound great, but if traders have trouble applying it, then what's the use? Aspiring traders know there is value in those technical tools, but they cannot quite figure them out -- and that is what frustrates them.

Having been in the business of both trading and educating traders and investors, I must admit I use many technical tools to determine my short-term and long-term approach to playing this game. I definitely use triangle setups as they are quite powerful. With ascending, symmetrical and descending triangles, each paints its own picture of possibilities, and all should be analyzed by every trader. There are methods and setups such as the 50-day test, doji candlestick patterns, and "inside days." Finally, stochastics and the RSI are invaluable in understanding when to buy, sell, or stay pat. Again, all of these tools are worthwhile for traders.

THE MACD
However, as far as I am concerned, there are only two true indicators in this game: (1) the combination of price/volume trends and (2) my favorite, MACD divergences. These are the true rulers of the market and I have used them and taught others to use them successfully for many years. (The key to using these approaches is in keeping it simple so as to actually be able to use this tool, and so this will be my mission for all of you today.)

Before focusing on MACD divergences, I should say there are many different time frames I have found to be useful. The best are the 60-minute or hourly, the daily and the weekly charts, all of which can reveal important divergences between the action of the indicator and the action of the market. Divergences in the 60-minute chart can alert you to changes in market direction that are about to occur within one to two days in most cases. Divergences in the daily chart tend to tell their tale within one to as many as five days, and divergences in the weekly chart can take from as little as three days to as long as two weeks when anticipating changes in market direction.

Nothing is exact, but these are general guidelines. The key is learning to trust these divergences when they occur and not lose patience when they do not work instantaneously. Unfortunately, many traders make just this mistake. Trading is an emotional game, and you need to trust that these divergences will work given a little leeway and time. I can say without exaggeration that MACD divergences work, if read properly, more than 75% of the time. But again, you need to read -- and trade -- them appropriately. I will teach you how to do just that, and I will give you some charts to look at as well.

Now that we understand the time frames that are best to refer to, let's talk about the parameters you should use when setting up your MACD. You should use the standard or default settings of 12, 26, 9. These numbers stand for the lengths of various moving averages: a 12-period moving average, a 26-period moving average, and a nine-period moving average. Understanding the relationship between these moving averages is key. Remember that a healthy, uptrending market is one in which the shortest-duration moving average is the highest. Markets are bullish when the 20-period moving average is higher than the 50-period moving average, and when the 50-period moving average is higher than the 200-period moving average. The same is true to the downside. A healthy, downtrending market will feature the shortest moving average as the lowest, followed by longer-term moving averages (that is, intermediate-term below longer-term).

There are two ways to read the MACD. The first method is called the MACD crossover. If you are trading the MACD crossover, then you are focused on which moving average line is the highest (using the bullish example) and when that "crossover" occurred. You know you have a bullish market if the 12-period moving average is over or crossing over the 26-period moving average. Conversely, you have a bearish market if the 12-period moving average is below or crossing below the 26-period moving average. This is the first step in learning how to recognize a market when it is about to switch direction from bullish to bearish or vice versa. Believe it or not, this is how you can outperform a market. By following the MACD, you are catching the turn in the market before it takes place. You are positioning yourself ahead of the masses.

DIVERGENCES
But what about "divergences"? The first step is simply watching price. What you want to do is compare the most recent highs or lows in terms of price. For example, let's say a stock in a downtrend makes a low at $50. The stock rises some ("bounces") and then comes back down and makes an equal or, better yet, a lower low. Let's say two weeks after hitting the low of $50 and bouncing, the stock came down and put in a low at $49.25. This would mean two lows in price, the second low lower than the first -- divergences to work with equal lows (that is, if the stock had bounced and come back to make a second low at $50), but lower lows are best.

The next step is to examine the MACD. First, look at the position of the MACD when the stock made the first low at $50, and then look at the position of the MACD when the stock made its second, lower low at $49.25. You have prices making lower lows, but -- and here's the key -- if the MACD is higher at $49.25 than it was at $50, then the MACD is creating a positive divergence.

The simple way to think about it is this: there wasn't as much selling pressure on the lower low. The MACD is diverging at the lower low in price by being higher versus itself at $50. The MACD is higher, even though the price of the stock is lower. This is the place to be buying.

From a negative or bearish perspective, let's say a stock is in an uptrend and makes a high of $70. The stock comes down and then three weeks later rises back up, this time to $72. If the MACD on the second high of $72 is lower than it was when the stock was at $70, you have a negative divergence. A negative divergence tells traders to think about selling long positions and possibly even going short.

Remember, you're comparing the most recent lows or highs to themselves. Again, the most recent! You are not comparing highs or lows from three or four highs or lows ago. The time frame on the daily or weekly charts should never be more than six weeks apart when comparing the most recent highs or lows to themselves. On the 60-minute charts, the space between the highs or lows should never be more than three weeks.

Let's look at an example of a MACD divergence. This example will feature a 60-minute chart as opposed to a daily chart and will include a well-known and well-loved stock, Apple, Inc. (Figure 1).


FIGURE 1: MACD DIVERGENCE AT WORK, HOURLY. On this chart of Apple, you can see that AAPL made a low on April 13 and a lower low on April 18. The MACD was forming higher highs, which indicates a positive divergence.

Shares of Apple (AAPL) fell into a falling wedge pattern late in March 2007. The stock had been moving higher over much of the month, but late in March reached a peak just shy of 97 and began a pattern of lower highs and lower lows throughout the balance of the month and the first half of April. For most of this decline, the MACD moved in tandem, rising when the price of AAPL rose and falling when the price of AAPL fell.

However, near the middle of April this relationship between AAPL and MACD changed. While the price continued to decline, the MACD began moving higher. AAPL made a low in the afternoon of April 13 and a lower low in the morning of April 18. At the same time that AAPL was forming lower lows, the MACD was forming higher highs -- specifically, the MACD was higher on April 18 than it was on April 13. This meant that there was a positive divergence in the hourly chart of AAPL and a strong possibility of higher prices in the very near future.

A week after that lower low in AAPL at about 89, the stock was closing above 95.

DIVERGENCES FOR ALL
MACD divergences work in all markets -- stocks, forex, futures. Not only is it a powerful, primary tool for trading, it is also what I use most in deciding which side of the market to be on and what stocks to buy or short for my investment/trading newsletter service. MACD divergences have been successful throughout the years, and I would encourage traders to take the time to learn as much as possible about how they work. Paper-trade them first to get yourself comfortable with them, and don't get too complicated. Compare the most recent higher highs or lower lows to themselves and look at the position of the MACD when those higher highs and lower lows are made, and you'll be on your way.



Jack Steiman

Jack Steiman is president of TheInformedTrader.com and Steiman New Research Group, LLC. He has served as a consultant for several stock market advisory groups and hedge funds but is most passionate about educating individual traders. He has accomplished this goal through his work conducting live seminars on technical analysis, hosting national radio shows, appearing on television, and running his own advisory and alert service.

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