Trading Basics – MACD – The MACD-Momentum (MACD-Mo) – Part 2

05/22/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In the last article, I gave an introduction to my modifications of the MACD, a convergence/divergence indicator originally developed by Gerald Appel. The examples last time demonstrated the basic interpretation of the MACD-His, and also illustrated that the MACD-His can be a very useful indicator, especially when two different time frames are used in conjunction. The slope of the MACD-His was also discussed, as sharp rallies or declines can reflect a change in buying and selling pressure. The weekly signals from the MACD-His do occasionally lag, and for that reason I developed the MACD-Momentum or MACD-Mo. It can be more sensitive to changes in the MACD-His and will often cross the zero line one to three weeks before the MACD-His.

First, it is probably important to illustrate how the MACD-Mo is calculated. In early years, while testing the MACD, I found that instead of the default values of 12, 24, and 9, the signals were more accurate when 10, 20, and 10 were used to calculate the exponential moving averages. This means that the MACD line (mentioned the last article) is derived by taking the difference between a 10- and 20-period exponential moving average, and then using a 10-period EMA of this difference to form the signal line. The MACD-Mo is then determined by running a 10-period momentum (with 3-period smoothing) of the MACD-His.

I have found it useful for traders to combine both the weekly and the daily MACD-Mo and MACD-His readings as a way to gauge how much weight the individual signals should be given. For example, when the weekly MACD-His and MACD-Mo are both positive, short-term peaks in the weekly MACD-Mo can be used as a signal to take some profits or to tighten your stops.

Figure 1
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The first chart shows the weekly and daily MACD-His and MACD-Mo readings for the S&P 500. On the bottom of the price chart, the blue histogram represents the MACD-His while the solid red line is for the MACD-Mo. For this discussion, we will look at just the last few months of this year and give you some ideas for what may lie ahead.

The weekly MACD-Mo made its low the week of October 21, 2005 (point 1) and then rose the following week, suggesting the correction was over. Four weeks later the S&P 500 closed above major resistance (line A) in the 1250 area. The daily MACD-Mo, as one would hope, gave an early warning of the weekly signal. It formed a bullish divergence in early October lows (line B) and then moved above the zero line on October 20, 2005 (point 2).

I have found that changes in trend in the MACD-Mo should be confirmed in 2-5 periods by the MACD-His. You will note that on the weekly chart the MACD-His did turn positive within five weeks of the MACD-Mo turning up. When the MACD-His on either the weekly or daily data fails to confirm the MACD-Mo it is consistent with a technical rebound, not a significant new up or downtrend.

The daily MACD-Mo for the S&P 500 did drop below the zero line in mid-November but the MACD-His stayed positive until early December. The fact that both the weekly studies were positive suggested a correction was likely, and that this was not an end to the rally from the October lows. In fact, the daily chart shows a classic continuation pattern (lines C and D). For those not comfortable or knowledgeable about classic chart analysis we will be doing several articles on this topic in the near future.

After the sharp rally from the October lows, the daily chart pattern does favor an upward resolution, and the daily MACD-Mo just moved above the zero line with the close on December 23 (point 3). The levels to watch are 1276 and 1249. A daily close above 1276 would signal a resumption of the recent uptrend, while a drop below 1249 would indicate that a deeper correction is likely.

Figure 2
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So, what types of stocks are likely to do best if the market does move higher in early 2006? The chart above (figure 2) shows the iShares S&P MidCap 400 Growth Index (IJK) and the iShares S&P SmallCap 600 Growth (IJT). As a group, the mid-caps performed well over 2005, up 12%, while the small-cap growth stock funds are up just 8.3%. This compares to a 4.3% gain for the S&P 500. The weekly MACD-His and MACD-Mo on both exchange traded funds (ETFs) are positive (not shown) and still rising. The daily MACD-Mo does act stronger for the Mid 400 Growth, as it could move above the zero line before year end (point 1). The recent corrective chart pattern (lines A and B) also looks stronger for the mid-caps. This suggests that the mid-caps should continue to do better than the small-caps in early 2006.

What stock markets did best in 2005? The overseas stock markets have clearly been the star performers, led by Latin America and Asia. The weekly charts below (figure 3) feature two ETFs, one of which is composed of Japanese stocks and the other by Latin American stocks. The iShares MSCI Japan Index (EWJ) is up slightly over 29% in the past year, while the iShares S&P Latin America (ILF) is up 56% and has been in a strong uptrend for the past 18 months.

The MACD–Mo on EWJ moved through the zero line in May 2005 (line A) and was confirmed by the MACD-His five weeks later. The fund had begun to accelerate to the upside. The MACD-Mo dropped below zero in November but this was not confirmed by the MACD-His, as it stayed positive. Now the MACD-Mo has turned up once more (point 1).

Figure 3
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The MACD readings for ILF have not been nearly as clear, which gives us a good example of how some momentum indicators do not work in strongly trending markets. The MACD’s both turned positive on June 6, 2005 (line B), as the fund accelerated to the upside. They remained positive until October when both dropped below the zero line. While the MACD-His is now back above the zero line, the MACD-Mo is not. Despite these conflicting signals ILF has continued to make new highs as it broke through the $130 level in early December.

The action of ILF illustrates the danger of just using momentum type indicators, which is why I favor combining a series of technical studies to help one filter out misleading signals. The OBV or On Balance Volume, discussed previously, is one of my favorites.

Figure 4
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For example, the weekly OBV on EWJ (figure 4) turned positive in April (point 1), a bit earlier than the MACDs, and then surged to the upside in late August. It still looks strong as it is well above its rising WMA and shows no divergences. This indicates that the weekly trend for EWJ remains quite positive.

The OBV on ILF (figure 4) has been generally positive since the third quarter of 2004, as it has generally stayed above its rising WMA. From March 15 through April 29 it dropped below its WMA, but soon reversed to the upside (point 2). In October it also turned negative for three weeks (point 3), but by early December, the OBV was again making new highs, signaling that demand was strong and that the uptrend was still intact.

I hope these last two examples will show you why I think it is difficult to trade successfully without using several technical tools, as well as why I think at least one of them needs to use volume. This is particularly true in strongly trending markets where price-only based indicators will eventually give misleading signals.

As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow''s MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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