Neither seemed to be perfect.Breadth is an interesting measurement, but don’t expect it to solve toomany problems. Most often, it will simply confirm the current price move.When it does stand out by conflicting with rising prices, volume and otherindicators also should show weakness.
OPEN INTEREST IN FUTURESThe stock market has a fixed number of shares that can be traded, theamount issued by each company. In futures markets the concept is different.When a new buyer trades with a new seller, they create a contract betweenthemselves. That contract is one unit of open interest.Each buy or sell in futures may create or liquidate a unit of open interest.If a new buyer finds a new seller, then a new contract is added to the totalopen interest. If a new buyer finds an old seller, then his unit of open interest(his outstanding obligation) is transferred to the new buyer and there isno change in open interest. When those contracts are liquidated, they are removed from the open interest.The larger the open interest, the more outstanding contracts exist andthe larger the participation in the market. A day trader who buys and sellsbut holds no positions overnight does not affect the open interest, which iscalculated at the end of the day. The table summarizes these relationships.Buyer
Seller
Change in Open Interest
NewNewOldOld
NewOldNewOld
Increase in open interestNo change in open interestNo change in open interestDecrease in open interest
A new buyer (seller) is a trader with no market posiition seeking to belong (short); an old buyer (seller) is a trader who had previouslyentered a short (long) position and seeks to exit.
Futures contracts, as with stock options, are traded for a specific delivery month, such as March, June, September, and December. When we
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use futures volume and open interest data, we must always use the total ofall contracts for that market, not the volume or open interest for the nearestor most active contract. Total volume and total open interest are interpretedas follows:Volume
Open Interest
RisingRisingFallingFalling
RisingFallingRisingFalling
Interpretation
Confirmation of trendPosition liquidation (the end of a trend)Slow accumulation of a positionCongestion phase, denies a trend
An increase in open interest means greater participation in a move. It ispossible to have high volume during the day because of day trading activity,but more open interest means that traders are going home with their position. High open interest during a trend means that the market is in stronghands and the trend is likely to persist. When it is in weak hands, it is likelyto fail.
ARE THERE TOO MANY INDICATORS?There is an underlying theme in the interpretation of volume, breadth, andopen interest. Increasing values confirm price direction, and decreasing values deny that direction. That is a valuable concept.However, which of these indicators should we use? Does a volume indicator tell you more than a simple volume spike or a sharp drop in volume atthe top of a move? If we look back at the OBV and VA in Figure 13.7, the finalresults don’t seem to be as good as simply using a moving average pricetrend. The VA implies that you should be holding the long position throughout, while the OBV is late exiting a long and entering a short.In the final analysis, when volume spikes or drops sharply lower duringa rising market, we get a reliable indicator of a change of direction. None ofthe indicators seem to improve on this simple interpretation.
Become Familiar with One IndicatorThe most important part of any indicator is the way you use it. When welooked at different moving average techniques, we concluded that they allworked when prices trended. All of these indicators will show the sameresult in slightly different ways. Pick one that seems most sensible to you,
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watch it, and become familiar with it. Most often, it will simply confirmprice movement, but once in a while it will show you that the direction ofprices is not supported by much activity. If it helps only a few times, it’svaluable.
ADVANCED TOPICSHow Do You Recognize an Extreme Volume DayUsing Excel?An extreme volume day is one that has a much wider range, from high to low,than previous days. You can recognize an extreme day ifToday’s volume > factor × average(volume from t − 6 to t − N)where factor should be at least 2.0 and N should be at least 20. Therefore,today’s volume is extreme if it is 3 times greater than the average volume ofthe 15 days from 6 days ago to 20 days ago.This satisfies the idea that today’s volume is much higher than normal. Italso avoids using the most recent five days in the average. Sometimes the volume increases gradually until it reaches an extreme. If you measure each dayagainst the previous day, you might not recognize an extreme, so we don’tlook at the most recent few days.
Low-Volume PeriodsLow volume is important because it is associated with lack of direction forprices. To recognize a low-volume period we need to have the average volumeover the past few days below a threshold value. That threshold varies withthe individual stock. Therefore, a low-volume day occurs whenAverage volume over the past N days < thresholdwhere the average might be 250,000 shares and N should be at least 5.
Questions1. What interpretation do you place on falling prices and falling volume?2. Would you say that volume trends are (a) clear and easy to interpret or
(b) require smoothing to avoid erratic values?
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3. If volume was high and prices closed unchanged, would you consider the
risk of trading (a) low, (b) normal, or (c) high?4. A volume spike usually corresponds with what price pattern?5. How do you calculate On-Balance Volume?6. Of all the volume patterns and indicators, which appears to be the most
definitive?7. If prices are falling, what would the market breadth need to do in order to
confirm the decline?8. In futures trading, if a new buyer meets an old seller, what happens to the
open interest?
C H A P T E R 14
Momentum and MACD
n this chapter we’ll focus on momentum, the speed of the price. Changesin the speed can be seen in different momentum indicators. Momentumindicators make up a very valuable set of tools. The most well-knownvariation of a momentum indicator is the moving average convergencedivergence (MACD), which gives extremely reliable forecasts of pricechanges.
I
MOMENTUMMomentum is speed. Then the momentum value M is the change of priceover a specific time period, such as a week:M = price(today) − price(N days ago)If N is 5, then we have the weekly momentum, the price change over a oneweek period. An important feature of momentum is that its value can be aslarge the biggest price move over the N days used in the calculation.A momentum indicator plotted below the prices in Figure 14.1 showsthat momentum is smoother than price. The more days used in the momentum calculation, the smoother the line. A 5-day or 20-day momentum has thesame effect as looking at weekly or monthly prices instead of daily prices.The weekly prices appear smoother than the daily and the monthly smootherthan the weekly.
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FIGURE 14.1
Momentum. In this chart of AOL the prices are on the top and the 20- and40-day momentum lines on the bottom. The 40-day momentum is smoother and has peaks andvalleys at about the same place as the price series. The 20-day momentum (gray) reaches its peaksooner than prices because the price swings last more than 20 days.
Interpreting MomentumThe momentum line doesn’t lag as we saw with a moving average. A 10-daymomentum simply answers the question, “How high or low is today’s pricecompared to 10 days ago?” In Figure 14.1 the scale to the right of themomentum lines shows that the momentum was as high as 20 and slightlybelow −10. For both the 20 and 40-day momentum lines that means pricesover any 20- or 40-day interval never gained more than $20 or fell morethan $15.The thinner gray line is a 20-day momentum. It peaks at the place wherethe largest move occurs over a 20-day period. The heavier line, a 40-daymomentum, peaks at the largest move of a 40-day period. The scale on theright measures the net price change over 20 or 40 days.Steadily Increasing Prices. One special feature of momentum that mustbe understood is that if prices continue higher at the same rate after 40days, the 40-day momentum indicator will go sideways. Therefore, pricescould be increasing, but the momentum line is not increasing.
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For example, the price of International Widgets starts at $10 andincreases by $1 every day. After 40 days it is $50 and the 40-day momentumis 40 (50 − 10 = 40). On the next day it again increases by $1. The price is $51and the 40-day momentum is 40 (51 − 11 = 40). As long as the price increasesby the same amount, the momentum remains the same. It’s the same as drivinga car. As long as you hold the accelerator at the same pressure, the car movesforward at the same speed. If the speed is unchanged, the momentum valueis unchanged.Acceleration. If the speed is the same when the momentum line is movingsideways, then prices must be accelerating (increasing in speed) when themomentum line is rising. It will also be accelerating to the downside whenmomentum is falling below zero. We will refer to speed and accelerationthroughout our study of momentum.
Momentum as a Trend IndicatorMomentum can be used as a trend indicator. We showed in Figure 14.1 thatthe longer the momentum calculation, the smoother the momentum line.It’s not as smooth as a moving average, but it is smoother than the actualprices. When the momentum moves above zero, the trend is up. When itmoves below zero, the trend is down. If a 20-day momentum line movesabove zero, then the price today is higher than the price 20 days ago, a legitimate reason for saying that prices are rising.You may notice that the momentum lines show a lot of small, erraticmoves. When using momentum to decide the trend, you may want to use asmall buffer zone, a filter, around zero so that a little erratic movement doesnot cause you to change position unnecessarily. For example, you can golong AOL when the momentum goes above 2 and short when it goes below–2. That will prevent jumping in and out if the value gets stuck around zero,as it might if prices are going sideways.
Comparing Momentum to a Moving AverageTo be sure that momentum really acts as a trend, we should compare it witha moving average. In Figure 14.2 20-day and 40-day moving averages areplotted along with prices on the top of the chart, and the previous 20-dayand 40-day momentum indicators are shown at the bottom.To compare the slower moving average with the slower momentum (thethicker lines), we look at where the moving average changes direction and
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FIGURE 14.2
Comparing momentum with moving averages. To compare the trendsof momentum with a moving average, we match the point where the moving average changesdirection with the point where the momentum crosses the zero line.
where the momentum crosses zero. In April 2001 the moving averageturns up at about $42; the momentum crosses the zero line moving higher atjust about the same day. When the moving average turns down in July, themomentum falls below zero at about the same time. You’ll find that the sameis true of the faster 20-day trends.We concluded at the end of Chapter 4, Calculating the Trend, that if themarket is trending, any of the trend calculations would be profitable. We cannow add the momentum trend to that list.
Detrending a Price Series Using MomentumMomentum can be used to remove the trend from a price series. A detrendedseries allows us to see the cyclic or oscillating patterns clearly. It is a methodused by economists.If we create a one-day momentum, we are looking at the one-day pricechanges by subtracting today’s price from the previous price. In mathematicsthis is called the first difference in price. The first difference also gives youthe speed. In Figure 14.3 the first differences of AOL are shown in the centerpanel. It is easy to see the daily volatility of price changes, but the overall
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FIGURE 14.3 The detrended AOL price series. Classic detrending is simply the one-dayprice changes (center panel), but you can also detrend AOL by subtracting the 40-day momentumfrom the current price (the bottom panel). Both methods remove the downtrend. The bottom panelusing momentum shows the cyclic pattern clearly, while the one-day changes show volatility.
trending pattern is sideways. The trend has been removed. We can alsodetrend the AOL series by subtracting a longer momentum value. In Figure14.3 the bottom panel shows the new series when a 40-day momentum is subtracted from the original price series. By using a longer momentum calculation, we also remove the trend bias but keep the cyclic pattern.By subtracting a momentum line of a different speed, we can choose tosee specific patterns in AOL that were not as obvious in the original series.We will use this technique to create the well-known indicator, MACD.
MOVING AVERAGE CONVERGENCE-DIVERGENCEThe moving average convergence-divergence (MACD) indicator is a smootheddifference between two smoothed trendlines. It is formed by creating a fasterand slower smoothed trendline from the original price series, subtractingthe slower one from the faster one, and finally applying another smoothingto the new series. If we choose the slow calculation period as 40 days, the
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fast period as 20 days, and the final smoothing as the 9-day equivalent, theMACD is calculated as follows:Step 1. Choose the two calculation periods, for example, slow = 40 and
fast = 20. Calculate the percentage smoothing values using 2 / (N + 1),where N is 40 or 20.Step 2. Calculate the slow trendline using the smoothing value .0243.Step 3. Calculate the fast trendline using the smoothing value .0476.Step 4. The MACD line, the slower oscillating line in the bottom panel of
Figure 14.4, is calculated as the fast trendline minus the slow trendline. When the market is moving up quickly, the fast smoothing willalways be above the slow and the difference will be positive. This isdone so that the MACD line goes up when prices go up.Step 5. The signal line is the 9-day smoothing (using a percentage of .10) of
the MACD line. The signal line is slower than the MACD; therefore,it can be seen in the bottom panel of Figure 14.4 as the lower linewhen prices are moving higher.
FIGURE 14.4
MACD. The MACD line is the faster of the two trendlines (gray) in the bottompanel; the signal line is the slower (dark). The histogram is created by subtracting the slowersignal line from the MACD line. This histogram shows the relative strength or weakness of theMACD compared to the signal line.
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Reading the MACD IndicatorWe normally see the MACD as it appears in the bottom panel of Figure 14.4.The MACD line is higher in an uptrend and lower in a downtrend. The histogram is created by subtracting the slower signal line from the MACD line.When the histogram is above zero, it confirms the uptrend.The 40/20 MACD line is similar to the 40-day momentum line. We cancompare the MACD in the lower panel with the 20- and 40-day momentum inthe center panel and see that the peaks and valleys are in about the sameplace, but the MACD line is much smoother. The MACD is a variation ofmomentum because it is the difference between two trendlines.
Trading the MACDThe most common use of the MACD is as a trend indicator. For that purpose,we use only the MACD and signal lines in the following way:Buy when the MACD line (faster) crosses above the signal line (slower).Sell when the MACD line crosses below the signal line.We can look at the bottom panel of Figure 14.4 to see that the buy signalsthat occur right after a bottom, in April and October 2001, generated largegains. Unfortunately, there were a lot of other crossings that generatedlosses. It is clear that we need to be more selective about these signals.One easy way to pick the good trades is to say that we only take the sellsignals that occur after the MACD goes above 2.00, and only the buy signalsafter the MACD has fallen below −2.00. That gives us a very nice buy signalin April, a sell in May, and a buy in October. However, if someone were looking over our shoulder, we would be accused of “fitting” the data. We lookedto see what worked for this chart and made up a rule to profit from it. Using+2.00 and −2.00 works for this chart, but some other charts will have peaksthat may be as high as +10. What looks as if it’s a top on this chart will turnout to be the middle of another chart.If you have some other way of deciding that prices are near a top, thenyou can select the signal crossover as your point to sell. One likely methodis to look for a strong resistance level on your price chart. If prices slow asthey rise into resistance, then you have a good chance that the MACD sellsignal will work. Using a much longer time period for your chart will also giveyou a better view of the possible range of MACD values.
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DIVERGENCEDivergence is one of the great concepts in technical analysis. Divergenceshows when prices are about to change direction.It is easier to show divergence in an illustration than in words. In Figure14.5 there is a bearish divergence in Amazon formed in October throughDecember 2000. It is bearish because it anticipates a drop in prices. To seethis divergence on the Amazon.com chart, follow the rules:1. Find the swing highs on the chart. This can be done simply by looking
at the highest peaks. In Figure 14.5 there are five significant peaks, thelargest in April and December 1999, medium peaks in October 1999 andFebruary 2000, and a small peak in July 1999.2. Find two consecutive peaks that are rising. They are July, October, and
December.3. Draw a line connecting the October and December peaks.
Divergence:Prices are rising
Indicator is falling
FIGURE 14.5 MACD divergence. In this divergence, prices are rising sharply while the MACDis falling. Sell the next crossover of the MACD line and signal line.
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4. Look at the MACD line directly below the October–December line that
you drew in the upper part of the chart. There always will be a peak inthe MACD corresponding to a peak in prices. Connect the two peaks in theMACD line.5. The line drawn across the price highs is rising sharply. The line across the
MACD peaks is falling slightly. Whenever these lines are angling in opposite directions, you have divergence.Bearish divergence occurs when the price moves higher and the indicator moves lower. This divergence is important because the MACD is not confirming the upward move, but indicating that prices want to go down. Pricesdrop from $110 to $60 in a few weeks.Bullish divergence is the opposite formation. Prices are dropping, butthe MACD is rising. Prices want to change direction. Figure 14.5 has anequally successful bullish divergence. Can you find it? The bullish divergencehas lower price lows in June and August with clearly rising lows in the MACDat the same time. The August price low marks the bottom of the move, and asubstantial rally follows.Divergence is one of the most successful of all indicators. When youstudy it closely, you find that the divergence is formed when the newhigh price peaks get farther and farther apart. Although not as apparent,a bearish divergence also is recognizing an irregular but rounded topformation.Divergence is most profitable when it is very clear, as it is in the bullishdivergence example. If the price peaks are nearly at the same height, thepeaks are not very big, or the MACD line is nearly horizontal, then the success of the divergence is doubtful. Unfortunately, the clear divergence signalsnever occur as often as we would like them, but they have a high degree ofsuccess. Watch for them.
Another Amazon Example of DivergenceEarlier in 1999 Amazon shows another clear bearish divergence (see Figure 14.6). Prices show peaks in January and April 1999. At the same timethe MACD peaks are clearly declining. Note that Amazon had a test of theJanuary highs three weeks before the major peak. At the time the secondMACD peak was much lower and a divergence seemed likely, but pricesdidn’t quite move above the first peak. As it turned out, this was not the
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Rising pricesNot a divergence
Falling MACD gives strong divergence signal
FIGURE 14.6
Another example of divergence in Amazon. In this bearish divergence,the MACD is much weaker on the second peak, indicating a strong divergence signal. Before theactual divergence, there is another peak that may be taken as a divergence; however, prices didnot make a new high.
top of the market, and the divergence signal would have been premature.Once the second price peak has been made in the bearish divergence,we look for the MACD line crossing the signal line heading down. We cannow sell.
Anticipating the DivergenceAs you become more comfortable with recognizing a divergence, you’ll wantto trade it as early as possible. So far, we enter a bearish divergence after wesee the second MACD peak form and recognize that it is lower than the previous MACD peak. We can do better than that.When a current price rally moves above the high of the previous rally(which happened about December 1 in Figure 14.5), we look at the MACD.The MACD value is less than 4.0 when prices break out to the upside. Theprevious MACD high was above 6.0. If prices were to turn now, we would
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have a strong divergence (the new MACD peak being much lower than theprevious peak). We should start selling now.Don’t sell everything at one time. Divide your capital into three parts:1. Sell the first third when prices make a new high and the MACD is much
lower.2. Sell the second part when the MACD line gets to within 15 to 20 percent
of the previous MACD high.3. Sell the third part when the MACD line crosses the signal line heading
down.If you only have one choice, you are better taking the second signal. If youhave two choices, take the first and second. If you look at the price when theMACD crossed the signal line, the third sell signal, you’ll see that your fillwould have been disappointing. Prices already had dropped significantly.
Exiting a Divergence TradeA bearish divergence is a special case of prices being overbought. Priceshave reached new highs but have slowed down and give every sign of wanting to reverse direction. As with other overbought situations, once priceshave returned to a neutral position, the trade is over. For divergence, thathappens when the value of the MACD reaches zero. It is a mistake to thinkthat prices will go from overbought to oversold.The Divergence Disappears. Not all trades are profitable. Although adivergence signal is reliable, it is not perfect. If you’ve sold a bearish divergence and prices start back up and the MACD value goes above the previousMACD peak, then the divergence formation has disappeared. The MACDpeaks are now rising, and you must exit your trade. Take your loss and lookfor the next divergence trade.Combining Divergence with a Trend. One very effective strategy is tocombine divergence with a trend. If you use a trend for you basic positions,watch for the formation of both bullish and bearish divergence patterns. Ifyou are long, then sell if a bearish divergence forms and watch the trend tosee if it also reverses. The best case is that when the MACD reaches zero, thetrend has turned down and you can hold your short position and continue tofollow the trend.
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HIGH-MOMENTUM TRADING—A GAME PLAYED BY PROFESSIONALSWe started this chapter looking at momentum. Momentum is the change inprice over some time interval, a number of days or hours. Momentum isstrongest as prices gain speed in a clear uptrend, or as they gain speed during a dramatic drop.We saw that momentum has peaks based on the span of the momentumcalculation. If we use a 10-day momentum, the peaks show the largest 10-daynet moves; if we use a 20-day momentum, the peaks will be higher than the10-day peaks and will show the largest 20-day moves.One quirk about using a short momentum period, for example, 10 days, isthat the momentum line will remain high if prices continue rising for morethan 10 days. If there is a 20-day rally, then the last 10 days will all post highmomentum values.In Figure 14.7, a chart of AOL, the 10-day momentum is shown along thebottom, and two horizontal lines have been drawn at +15 and −15 to showthe extremely high and low momentum values. It would be possible, although
FIGURE 14.7 Trading high-momentum periods. Professional traders will buy when pricesare moving fast and hold the trade for a short time. High-momentum periods, when the momentum value is above the horizontal line, show where prices are rising quickly and accelerating.
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risky, to sell when momentum crosses the upper band and buy when itcrosses the lower band. We saw in previous charts that momentum usuallydoesn’t remain at a high level for long.
Trading above the ThresholdSome professional traders have made a business of trading in the direction ofthe trend only when momentum exceeds a high threshold level (for example,+15) rather than looking for a change of direction. There is a lot of moneyto be made because prices are moving fast. There is also a great deal of risk.High-momentum trades are held for only a short time—a few minutes or afew hours for day traders, two or three days for longer-term traders.Price patterns have changed over the past five years. There are manymore day traders. When one stock breaks out above a previous high, everyone sees it as an opportunity for profit. Buy orders start to flow and volumeincreases. Stocks that are normally ignored can attract large volume whenprices make a new high. Traders ride the rising price for as long as possible,watching to see when volume begins to drop, and then they exit. They mayjust target a modest profit and get out.It’s a fast game that requires tools that allow you to scan a wide range ofstocks looking for one that has made a new high after a long, quiet period.You need to stay glued to your screen, enter fast, and exit fast. It’s a businessfor the professional trader, and it’s not easy.
TRADING GAME TIPSGold shares and gold prices. Is there a relationship between gold shares andgold prices? Yes, if the company is not so diversified that the mining operation is only a small part of its revenue. You can then watch the cash price ofgold and look for support and resistance levels that occur at the same placefor both the share price and the physical gold price (see Figure 14.8).General Electric and electricity prices. Don’t think for a moment thatthe price of GE has anything to do with the price of electricity. GE is a massive financial company. Light bulbs and electricity round off the end of itsbalance sheet.
Questions1. If the last five prices of IBM were $40.25, $40.75, $41.25, $40.75, and
$41.50, what is the value of the five-day momentum?
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FIGURE 14.8 Barrick Gold (ABX) compared to physical gold prices. You can gain extrainsight, as well as confirmation of technical signals, by comparing gold stocks with the price ofphysical gold.
2. Which one of the 20-day or 40-day momentum lines can potentially have
the highest value?3. When two consecutive momentum values are 1.50 and 1.50, are prices
(a) increasing, (b) unchanged, or (c) decreasing?4. When two consecutive momentum values are 2.50 and 1.50, are prices
(a) increasing, (b) unchanged, or (c) decreasing?5. If you are using momentum as a trend indicator, at what point does the
trend turn up?6. If you are using the MACD as a trending indicator, when do you get a sell
signal?7. How would you improve the reliability of a standard MACD trending sell
signal?8. Describe an MACD bearish divergence.9. What would make you consider one bullish divergence as stronger than
another?10. If you were anticipating a bearish divergence and planned to make two
sales, when would you sell?
C H A P T E R 15
Overbought/OversoldIndicators andDouble Smoothing
hen we watch the way a stock price moves, we form expectations.When the price breaks out above a previous high, we expect continued higher movement because something new has happened.When prices move up exceptionally fast, we expect them to stop and reverse.Prices can’t accelerate upward forever. We call a market that has gone upunusually far or unusually fast overbought. A stock that has dropped in thesame way is called oversold.We can decide that a stock or index is overbought or oversold in twoways. The “quants” will statistically measure the fluctuations in price movement over the past, create a profile, and then say that the current move isextreme. Before mathematical analysis was so easily done on a computer,overbought and oversold conditions were decided by market sentiment.Market sentiment is still popular and just as valid today.
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MARKET SENTIMENT—OPINION AND CONTRARY OPINIONMarket sentiment is the driving force of the market. Prices don’t go up unlessinvestors believe they will go up and are willing to back up their opinion withmoney. Although there is a constant flow of funds into pension plans, whichworks its way into the market, investors will draw money out if they see agloomy forecast for the next six months. We might conclude at first that ifconsumer confidence is rising, then we should buy and if it is falling, weshould sell.Is the public always right? We expect prices to rise if the general publicis comfortable putting their pension money into the market in large numbers,213
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allocating a larger percentage to stocks and putting less into fixed income,such as bonds.What happens when prices have been rising steadily, as in the mid-1990s,and the public becomes enamored by the returns of the stock market, whenthey expect to get more than 20 percent each year? Isn’t that an overboughtsituation?
Contrary OpinionContrary opinion is a theory that when the public is overly confident in itsbelief that the market will continue higher, it is time to sell or, at least, timeto get out of your long stock holdings and look for a place to sell. Extremecases justify this approach. The most famous of all events in which the public was wrong are documented in Charles Mackay’s Extraordinary PopularDelusions and the Madness of Crowds (