Shares digital

Last week we talked generally about momentum and indicators that can help in assessing it. Broadly speaking, a market or share can do one of three things; go up, go down or go sideways in a largely directionless manner. The first two options involve a trend while the latter does not. Of course it might be that a particular market (or share) is trending on its weekly or monthly time scale chart, however, on the daily chart this is not so evident. So, how best to cope with this? Typically we use trend following techniques when we are sure we are in a trend and these could be trend lines or moving averages for example. When we do not see a trend then we need to be aware that the market (or share price) is in a period of indecision and therefore likely to oscillate. We can use indicators such as the RSI or Stochastics to give us warnings of the market being oversold or overbought within this phase.

However, the most profitable trades come from riding a trend and many chartists would contend that the purpose of charting is to isolate a trend as early as possible and ride it for as long as possible. The MACD or moving average convergence divergence study, originally developed by Gerald Appel, is a deceptively simple study that helps in this endeavour, being a plot of the difference between two exponentially weighted moving averages (a 13 period and a 26 period one). Overlayed on to this is a nine period exponential moving average of this first line, this is the signal line. As the main line rises through the signal line the possibility of a long trade should be considered and when the main line drops below the signal line then the reverse needs thinking about. The use of two moving exponential averages to create the main line helps to smooth out smaller market fluctuations and noise to some extent, and helps to minimise false signals.

As with other indicators its use can be developed by looking for divergence between successive peaks or troughs and those that correspond in the price chart. Some systems also plot the difference between the MACD line and its signal line in the form of a histogram chart to help make reading it easier. Inevitably a sideways market can risk whipsawing between being long and short, however, it is worth remembering that the indicator’s signals are stronger when it is significantly above or below the zero line and a further refinement is to only go long when the signal is given below the zero line and go short when the cross of the line and its signal occurs above the zero line, unless divergence is present in either case. I have also seen the maths for MACD turned around to form a rather effective stop loss line too.

The indicator has been particularly effective when used on a monthly interval bar chart, correctly calling the major turns.