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INDICATORS
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
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
LISA HANEY
very narrow price range. profit alert pattern. (See sidebar The bar count.) Count the
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.
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.
PTX
A A A
A
PTX
PTX
PTX
A
A
A
PTX
A PTX
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
False Alert PTX
such false alerts during both the DecemberJanuary
A
downmove and the FebruaryMarch upmove. In the Decem-
ber 1997January 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
1997 move of the solid line toward the dotted produced a false alert because there
registered on January 22, 1998.
were fewer than 10 price bars at the conclusion of the potential alert. The valid alert
During the JanuaryFebruary 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
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 linestyle 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.