Sell signals are given when the fast line crossesbelow the slow line. These rules help catch all the major trendsand generate fewer whipsaws than crossovers of prices and a sin-gle moving average.
 
2. When the fast line crosses below the slow line, it gives a sell signal.Go short, and place a protective stop above the latest minor high(Figure 26-2).
More on MACD
Many traders try to optimize MACD by using other moving averages thanthe standard 12-, 26-, and 9-bar EMAs; 5-34-7 is another popular choice.Some traders try to link MACD to market cycles. The trouble is cycles arenot present in the markets most of the time (see Section 36). If you usecycles, the first EMA should be one quarter the length of the dominant cycleand the second EMA half the cycle length. The third EMA is a smoothingdevice whose length does not have to be tied to a cycle. Beware of optimiz-26. MOVING AVERAGE CONVERGENCE-DIVERGENCE 131
ing MACD too often. If you fiddle with MACD long enough, you can makeit give you any signal you want using the same data.
A “quick-and-dirty” way to plot MACD is used by traders whose soft-ware does not include this indicator. Some packages allow you to draw onlytwo EMAs. In that case, you can use crossovers between two EMAs, such as11-day and 26-day EMAs as a proxy for MACD and Signal lines.
MACD-Histogram
MACD-Histogram offers a deeper insight into the balance of power betweenbulls and bears than the original MACD. It shows not only whether bulls orbears are in control but also whether they are growing stronger or weaker. Itis one of the best tools available to a market technician.
MACD-Histogram = MACD line — Signal line
MACD-Histogram measures the difference between the MACD line andthe Signal line (see worksheet, Figure 26-1). It plots that difference as a his-togram — a series of vertical bars. That distance may appear puny, but a com-puter rescales it to fill the screen.
If the fast line is above the slow line, MACD-Histogram is positive andplotted above the zero line. If the fast line is below the slow line, MACD-Histogram is negative and plotted below the zero line. When the two linestouch, MACD-Histogram equals zero.
When the spread between the MACD and Signal lines increases, MACD-Histogram becomes taller or deeper, depending on its direction. When thetwo lines draw closer, MACD-Histogram becomes shorter.
The slope of MACD-Histogram is defined by the relationship betweenany two neighboring bars. If the last bar is higher (like the height of lettersm-M), the slope of MACD-Histogram is up. If the last bar is lower (like thedepth of letters Pp), then the slope of MACD-Histogram is down.
Market Psychology
MACD-Histogram shows the difference between long-term and short-termconsensus of value. The fast MACD line reflects market consensus Over ashorter period. The slow Signal line reflects market consensus over a longerperiod. MACD-Histogram tracks the difference between these two lines.132 COMPUTERIZED TECHNICAL ANALYSIS
The slope of MACD-Histogram identifies the dominant market group. Atising MACD-Histogram shows that bulls are becoming stronger. A fallingMACD-Histogram shows that bears are becoming stronger.
When the fast MACD line rallies faster than the slow Signal line, MACD-Histogram rises. It shows that bulls are becoming stronger than they havebeen —it is a good time to trade from the long side. When the fast MACDline drops faster than the slow line, MACD-Histogram falls. It shows thatbears are becoming stronger — it is a good time to trade from the short side.
When the slope of MACD-Histogram moves in the same direction asprices, the trend is safe. When the slope of MACD-Histogram moves in adirection opposite to that of prices, the health of the trend is questioned. It isbest to trade in the direction of the slope of MACD-Histogram because itshows whether bulls or bears dominate the market.
The slope of MACD-Histogram is more important than its position aboveor below the centerline. The best sell signals are given when MACD-‘Histogram is above its centerline but its slope turns down, showing that bullshave become exhausted. The best buy signals occur when MACD-Histogramis below its centerline but its slope turns up, showing that bears have becomeexhausted.
Trading Rules
MACD-Histogram gives two types of trading signals. One is common andoccurs at every price bar. The other is rare and occurs only a few times ayear in any market — but it is extremely strong.
The common signal is given by the slope of MACD-Histogram (Figure26-3). When the current bar is higher than the preceding bar, the slope is up.It shows that bulls are in control and it is time to buy. When the current bar islower than the preceding bar, the slope is down. It shows that bears are incontrol and it is time to be short. When prices go one way but MACD-Histogram moves the other way, it shows that the dominant crowd is losingits enthusiasm and the trend is weaker than it appears.
1. Buy when MACD-Histogram stops falling and ticks up. Place a pro-tective stop below the latest minor low.
2. Sell short when MACD-Histogram stops rising and ticks down. Placea protective stop above the latest minor high.
MACD-Histogram ticks up and down on the daily charts so often that is26. MOVING AVERAGE CONVERGENCE-DIVERGENCE 133
      
   
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MACD-Histogram
 
  
    
 
prFigure 26-3. MACD-Histogram Divergences
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MACD-Histogram confirms trends when it reaches new highs or lowstogether with prices. The new lows in MACD-Histogram at points A andF confirm downtrends. New lows in the indicator tell traders that thedowntrend is likely to retest or exceed bottoms A and F. New highs Cand D in MACD-Histogram confirm uptrends. They show that theuptrend is likely to retest or exceed peaks C and D.
Divergences between MACD-Histogram and prices identify majorturning points. These signals rarely occur, but when they do, they oftenlet you catch major reversals and the beginnings of new trends. Thebullish divergence A-B flags a major buying opportunity. Prices are at anew low, but the indicator is tracing a higher bottom. It shows that bearsare exhausted and bulls are ready to gain the upper hand.
The bearish divergence D-E identifies a major selling opportunity. Atthe right edge of the chart, there is a bullish divergence, F-G. The besttime to buy is when MACD-Histogram ticks up from its second bottom,G. Once you go long, place a protective stop below the price bottom G.Move the stop up as the trend progresses.
                                                  
not practical to buy and sell every time it turns. The changes of slope ofMACD-Histograms are much more meaningful on the weekly charts, whichis why it is included in the Triple Screen trading system (see Section 43).134 COMPUTERIZED TECHNICAL ANALYSISWhen to Expect a New Peak or Valley
MACD-Histogram works like headlights on a car —it gives traders a glimpseof the road ahead. New highs and lows in this indicator are usually followedby new high or low prices.
A record peak for the past three months in daily MACD-Histogram showsthat bulls are very strong and prices are likely to rise even higher. A recordnew low for MACD-Histogram for the past three months shows that lowerprices are likely ahead.
When MACD-Histogram reaches a new high during a rally, the uptrend ishealthy and you can expect the next rally to retest or exceed its previouspeak. If MACD-Histogram falls to a new low during a downtrend, it showsthat bears are strong and prices are likely to retest or exceed their latest low.
The Strongest Signal in Technical Analysis
Divergences between MACD-Histogram and prices occur only a few times ayear in any given market, but they give some of the most powerful messagesin technical analysis. These divergences identify major turning points andgive “extra-strength” buy or sell signals. They do not occur at every impor-tant top and bottom, but when you see one, you know that a major reversal isprobably at hand.
When prices rally to a new high, but MACD-Histogram traces a lowertop, it creates a bearish divergence (Figure 26-3). A lower top in MACD-Histogram shows that bulls are internally weak even though prices arehigher. When bulls are running out of steam, bears are ready to grab control.Bearish divergences between MACD-Histogram and prices identify weak-ness at market tops. They give sell signals when most traders feel excitedabout a breakout to a new high!
3. Sell short when MACD-Histogram ticks down from its second, lowertop, while prices are at a new high. Place a protective stop above thelatest high.
As long as prices keep falling to new lows and MACD-Histogram keepsgoing lower, it confirms the downtrend. If prices fall to a new low butMACD-Histogram traces a more shallow low, it creates a bullish divergence.It shows that prices are falling out of inertia, bears are weaker than theyseem, and bulls are ready to gain control. Bullish divergences between27. THE DIRECTIONAL SYSTEM 135
MACD-Histogram and prices identify strength at market bottoms. They givebuy signals when most traders feel fearful about a breakdown to a new low!
4. Buy when MACD-Histogram ticks up from its second, more shallowbottom while prices are at a new low. Place a protective stop below thelatest low.
If a bullish divergence between MACD-Histogram and price is abortedand prices fall to a new low, you will be stopped out. Continue to watchMACD-Histogram. If it traces a more shallow third bottom while pricesdecline to a new low, you are dealing with a “triple bullish divergence” — anespecially strong buy signal. Buy again as soon as MACD-Histogram ticksup from its shallow third bottom. ‘The reverse applies to shorting triple bear-ish divergences.
More on MACD-Histogram
MACD-Histogram works in any timeframe: weekly, daily, and intraday. Thesignals of weekly MACD-Histogram lead to greater price moves than thedaily or intraday indicators. This principle applies to all indicators — signalsin longer timeframes lead to greater price moves.
When you use MACD and MACD-Histogram on the weekly charts, youdo not have to wait until Friday to get your signals. A major trend canchange in the middle of the week —the market does not watch the calendar.Because of this, weekly studies have to be performed each day.
27. THE DIRECTIONAL SYSTEM
The Directional system is a trend-following method. It was developed by J.Welles Wilder, Jr., in the mid-1970s and modified by several analysts. TheDirectional system identifies trends and shows when a trend is moving fastenough to make it worth following. It helps traders take chunks of profit outof the middle of important trends.
How to Construct the Directional System
Directional Movement is defined as the portion of today’s range that is out-side of the previous day’s range. The Directional system checks whether136 COMPUTERIZED TECHNICAL ANALYSIS
Japanese Yen
Figure 27-1. Directional System Worksheet
+D1; 3 and —D1, 3 are based on positive and negative directional movementsand the true ranges of the past 13 days. DX is derived from +Dl,3 and-Dl; 3, and ADX is made by smoothing DX. See formulas in the chapter.
 
today’s range extends above or below the previous day’s range and averagesthat data over a period of time. These complex calculations (see worksheet,Figure 27-1) are best performed on a computer. The Directional system isincluded in most software programs for technical analysis.27. THE DIRECTIONAL SYSTEM 137
1.
Identify “Directional Movement” (DM) by comparing today’s high-to-low range with yesterday’s high-to-low range. DirectionalMovement is the largest part of today’s range outside of yesterday’srange. There are four types of DM (Figure 27-2). DM is always a posi-tive number (+DM and —DM refer simply to movement above orbelow yesterday’s range).
. Identify the “True Range” (TR) of the market you analyze. It is
always a positive number, the largest of three:
A. The distance from today’s high to today’s low
B. The distance from today’s high to yesterday’s closeC. The distance from today’s low to yesterday’s close
. Calculate daily Directional Indicators (+DI and —D)). They allow
you to compare different markets by expressing their directionalmovement as a percentage of each market’s true range. Each DI is apositive number: +DI equals zero on a day that has no directionalmovement up; —DI equals zero on a day that has no directional move-ment down.
+DM -DM+DI = ———_—- -DI = ————TR TR
. Calculate smoothed Directional Lines (+DIy3 and -DIy3). Smooth
+DI and —DI are created with moving averages. Most software pack-ages allow you to pick any period for smoothing, such as a 13-daymoving average. You get two indicator lines: smoothed Positive andNegative Directional lines, +DI,3 and ~DIj3. Both numbers are posi-tive. They are usually plotted in different colors, or as a solid and adashed line.
The relationship between Positive and Negative lines identifies trends.When +DIj3 is on top, it shows that the trend is up, and when —DI,3is on top, it shows that the trend is down. The crossovers of +DI,3 and~D113 give buy and sell signals.
. Calculate the Average Directional Indicator (ADX). This unique
component of Directional system shows when a trend is worth follow-ing. ADX measures the spread between Directional Lines +Dl13 andDI}. It is calculated in two steps:138 COMPUTERIZED TECHNICAL ANALYSIS
 
Directiona MoveMENT
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Figure 27-2. Directional Movement
Directional Movement is the largest part of today's range that is outside ofyesterday's range.
A. If today's range extends above yesterday's range, DirectionalMovement is positive (+DM).
B. If today's range extends below yesterday's range, DirectionalMovement is negative (-DM).
C. If today's range is inside of yesterday's range or extends above andbelow it by equal amounts, there is no Directional Movement (DM =0). If today's range extends both above and below yesterday's range,DM is positive or negative, depending on which part of the "outsiderange" is larger.
. Ona limit up day, +DM equals the distance from today's close to yes-terday's high. On a limit down day, -DM equals the distance fromtoday's close to yesterday's low.
 
A. Calculate the daily Directional Indicator DX:
+DI,3--DIpx-— 3 8 100+DIy3 +-D]y327. THE DIRECTIONAL SYSTEM 139
For example, +DI13 = 34; -DI13 = 18. Then,
34-18 16DX = ———_———- - 100 = ———_ - 100 = 30.77, rounded off = 3134+ 18 52
B. Calculate the Average Directional Indicator ADX by smoothingDX with a moving average, such as a 13-day EMA.
When a trend proceeds in a healthy manner, the spread between twosmoothed Directional lines increases and ADX rises. ADX declines when atrend reverses or when a market enters a trading range. It pays to use a trend-following method when ADX rises and not when ADX declines.
Crowd Behavior
The Directional system tracks changes in mass bullishness and bearishnessby measuring the capacity of bulls and bears to move prices outside of theprevious day’s range. If today’s high is above yesterday ’s high, it shows thatthe market crowd is becoming more bullish. If today’s low is below yester-day’s low, it shows that the market crowd is becoming more bearish.
The relative position of Directional lines identifies trends. When thePositive Directional line is above the Negative Directional line, it shows thatbullish traders dominate the market. When the Negative Directional linerises above the Positive Directional line, it shows that bearish traders arestronger. It pays to trade in the direction of the upper Directional line.
The Average Directional Indicator ADX rises when the spread betweenDirectional lines increases. This shows that market leaders are becomingstronger, losers are getting weaker, and the trend is likely to continue. Whenthe ADX rises, it pays to trade in the direction of the upper Directional line,using a trend-following method.
ADX declines when the spread between +DI,3 and ~DI,3 narrows down.This shows that the dominant market group is losing its strength, while theunderdogs are gaining. Then the market is in turmoil, and it is better not touse trend-following methods.
Trading Rules
1, Trade only from the long side when +D113 is above -D1,3. Trade onlyfrom the short side when —D1j3 is above +DI}3. The best time to belong is when both +D1,3 and ADX are above —DI,3 and ADX rises.This shows that the uptrend is getting stronger. Go long and place a140 COMPUTERIZED TECHNICAL ANALYSIS
Japanese Yen
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Directional System
 
Figure 27-3. Signals of the Directional System
Directional lines identify trends. When +DI is on top, the trend is up,and it pays to trade the market from the long side. When —D1 is on top, itshows that the trend is down and it pays to trade the market from theshort side. The best time to use a trend-following method is when ADX isrising and is above the lower Directional line. Those are two signs ofdynamic trends.
The Directional system gives its best signals after ADX spends severalweeks below both Directional lines. That happens in quiet, dull markets.Once ADX “wakes up" and rises by four steps (for example, from 10 to14), it gives a strong signal to trade in the direction of the upperDirectional line. It often flashes this signal at the beginning of major mar-ket moves. On this chart, ADX rallied from 9 to 13 in September, justprior to a dynamic rally in the Japanese Yen. Since the +DI was on topwhen the signal occurred, it signalled to go long.
 
protective stop below the latest minor low. The best time to be short iswhen -DI,3 and ADX are above +DI,3 and ADX rises. This showsthat bears are becoming stronger. Go short and place a protective stopabove the latest minor high.
2. When ADX declines, it shows that the market is becoming less direc-27. THE DIRECTIONAL SYSTEM 141
tional. There are usually many whipsaws, just as there are turbulencesin the water during the change of tide. When ADX points down, it isbetter not to use a trend-following method.
3. When ADX falls below both Directional lines, it identifies a flat,sleepy market. Do not use a trend-following system but start gettingready, because major trends emerge from such lulls.
4. The single best signal of the Directional system comes after ADX falls
below both Directional lines. The longer it stays there, the stronger thebase for the next move. When ADX rallies from below both Directionallines, it shows that the market is waking up from a lull. When ADXrises by four steps (i.e., from 9 to 13) from its lowest point below bothDirectional lines, it “rings a bell” on a new trend. It shows that a newbull market or bear market is being born (Figure 27-3). Buy if +D1,3 ison top and place a stop below the latest minor low. Sell short if -DI,3 ison top and place a stop above the latest minor high.For example, if ADX rises from 8 to 12 while both lines are above 12and +D113 is on top, it indicates that a new uptrend is beginning. IfADX rises from 9 to 13 while both lines are above 13 and —D];3 is ontop, it shows that a new downtrend is starting.
The Directional System is unique in telling you when a major new trend islikely to begin. It rings a bell once or twice a year in any given market. Itsignals when a new baby bull or baby bear is being born. Monetary risk isusually low at that time, due to low volatility while the trend is still young.
5. When ADX rallies above both Directional lines, it identifies an over-heated market. When ADX tums down from above both Directionallines, it shows that the major trend has stumbled. It is a good time totake profits. If you trade multiple contracts, you definitely want to takepartial profits.
Market indicators give hard signals and soft signals. For example, a viola-tion of a price low or a change in direction of a moving average are hard sig-nals. A downturn of ADX is a soft signal. Once you see ADX tum down,you ought to be very, very careful about adding to positions. You should starttaking profits, reducing positions, and looking to get out of your positionrather than adding to it.142 COMPUTERIZED TECHNICAL ANALYSIS
28. MOMENTUM, RATE OF CHANGE, ANDSMOOTHED RATE OF CHANGE
When greed or fear grips a mass of traders, the crowd surges. Oscillatorsmeasure the speed of that surge and track its momentum.
Technical indicators are divided into three main groups. Trend-followingindicators help identify trends. Oscillators help find turning points.Miscellaneous indicators, such as the New High-New Low Index, track gen-eral changes in mass psychology.
Oscillators identify the emotional extremes of market crowds. They allowyou to find unsustainable levels of optimism and pessimism. Professionalstend to fade those extremes. They bet against them, for a return to normalcy.When the market rises and the crowd gets up on its hind legs and roars fromgreed, professionals sell short. They buy when the market falls and thecrowd howls in fear. Oscillators help them to time those trades.
Overbought and Oversold
Martin Pring compares trend-following indicators and oscillators to the foot-prints of a man walking his dog on a leash. The man leaves a fairly straighttrail — like a trend-following indicator. The dog’s trail swings right and left asfar as the leash allows — like an oscillator. When the dog reaches the end ofits leash, it is likely to turn and run the other way.
You can follow the trail of a man to find the trend of the pair. When thedog deviates from that trail by the length of its leash, it usually turns around.Usually, but not always. If a dog sees a cat or a rabbit, it may become excitedenough to pull its owner off his trail. Traders need to use judgment whenusing oscillator signals.
An oscillator becomes overbought when it reaches a high level associatedwith tops in the past. Overbought means too high, ready to turn down. Anoscillator becomes oversold when it reaches a low level associated with bot-toms in the past. Oversold means too low, ready to tum up.
Overbought and oversold levels are marked by horizontal reference lineson the charts. The proper way to draw those lines is to place them so that anoscillator spends only about 5 percent of its time beyond each line. Placeoverbought and oversold lines so that they cut across only the highest peaksand the lowest valleys of an oscillator for the past six months. Readjust theselines once every three months.28. MOMENTUM 143
When an oscillator rises or falls beyond its reference line, it helps a traderto pick a top or a bottom. Oscillators work spectacularly well in tradingranges, but they give premature and dangerous trading signals when a newtrend erupts from a range. When a strong trend begins, oscillators start actinglike a dog that pulls its owner off his path.
An oscillator can stay overbought for weeks at a time when a new, stronguptrend begins, giving premature sell signals. It can stay oversold for weeksin a steep downtrend, giving premature buy signals. Knowing when to useoscillators and when to rely on trend-following indicators is a hallmark of amature analyst (see Section 43).
Types of Divergences
Oscillators, as well as other indicators, give their best trading signals whenthey diverge from prices. Bullish divergences occur when prices fall to a newlow while an oscillator refuses to decline to a new low. They show that bearsare losing power, prices are falling out of inertia, and bulls are ready to seizecontrol. Bullish divergences often mark the ends of downtrends.
Bearish divergences occur in uptrends — they identify market tops. Theyemerge when prices rally to a new high while an oscillator refuses to tise toanew peak. A bearish divergence shows that bulls are running out of steam,prices are rising out of inertia, and bears are ready to take control.
There are three classes of bullish and bearish divergences (Figure 28-1).Class A divergences identify important turning points —the best tradingopportunities. Class B divergences are less strong, and class C divergencesare least important. Valid divergences are clearly visible— they seem to jumpfrom the charts. If you need a ruler to tell whether there is a divergence,assume there is none.
Class A bearish divergences occur when prices reach a new high but anoscillator reaches a lower high than it did on a previous tally. Class A bear-ish divergences usually lead to sharp breaks. Class A bullish divergencesoccur when prices reach a new low but an oscillator traces a higher bottomthan during its previous decline. They often precede sharp rallies.
Class B bearish divergences occur when prices make a double top but anoscillator traces a lower second top. Class B bullish divergences occur whenprices make a double bottom but an oscillator traces a higher second bottom.
Class C bearish divergences occur when prices rise to a new high but anindicator stops at the same level it reached during the previous rally. It shows144 COMPUTERIZED TECHNICAL ANALYSIS
 
 
 
 
Figure 28-1. Types of Divergences
Divergences between prices and indicators give some of the most pow-erful signals in technical analysis. Divergences are defined by the differ-ences in height or depth of prices and indicators.
Class A bearish divergence-prices reach a new peak while an indicatorreaches a lower peak. This is the strongest sell signal.
Class A bullish divergence—prices fall to a new low while an indicatorstops at a more shallow low than before. This is thestrongest buy signal.
Class B bearish divergence-prices trace a double top while an indicatorreaches a lower peak. This is the second strongest sellsignal.
Class B bullish divergence—prices trace a double bottom while an indica-tor traces a higher second bottom. This is the secondstrongest buy signal.
Class C bearish divergence-prices reach a new peak while an indicatortraces a double top. This is the weakest bearish diver-gence.
Class C bullish divergence—prices fall to a new low while an indicatormakes a double bottom. This is the weakest bullishdivergence.
 28. MOMENTUM 145
that bulls are becoming neither stronger nor weaker. Class C bullish diver-gences occur when prices fall to a new low but the indicator traces a doublebottom.
Class A divergences almost always identify good trades. Class B and Cdivergences more often lead to whipsaws. It is best to ignore them, unlessthey are strongly confirmed by other indicators.
Triple Bullish or Bearish Divergences consist of three price bottoms andthree oscillator bottoms or three price tops and three oscillator tops. They areeven stronger than regular divergences. In order for a triple divergence tooccur, a regular bullish or bearish divergence first has to abort. That’sanother good reason to practice tight money management! If you lose only alittle on a whipsaw, you will not suffer—and you will have both the moneyand psychological strength to re-enter a trade.
Momentum and Rate of Change
Momentum and Rate of Change measure trend acceleration — its gain or lossof speed. These leading indicators show when a trend speeds up, slowsdown, or maintains its rate of progress. They usually reach a peak before thetrend reaches its high and reach a bottom before prices hit their low.
As long as oscillators keep reaching new highs, it is safe to hold longpositions. As long as they keep reaching new lows, it is safe to hold shortpositions. When an oscillator reaches a new high, it shows that an uptrendis gaining speed and is likely to continue. When an oscillator traces a lowerpeak, it shows that an uptrend has stopped accelerating, like a rocket thathas run out of fuel. When it flies only because of inertia, you have to getready for a reversal. The same reasoning applies to oscillator lows indowntrends.
Momentum and Rate of Change compare today’s closing price to a price aselected period of time ago. Momentum subtracts a past price from today’sprice; Rate of Change divides today’s price by a past price.
 
ProdM=Pioq-Ptod—-n ROC =tod—nwhere M = Momentum.RoC = Rate of Change.Piod = Today’s closing price.
Piod—n Closing price n days ago (chosen by trader).146 COMPUTERIZED TECHNICAL ANALYSIS
For example, a 7-day Momentum of closing prices equals today’s closingprice minus the closing price 7 days ago. Momentum is positive if today’sprice is higher, negative if today’s price is lower, and at zero if today’s priceequals the price of 7 days ago. The slope of the line connecting momentumvalues for each day shows whether momentum is rising or falling.
A 7-day Rate of Change (RoC) divides the latest price by the closingprice 7 days ago. If they are equal, RoC equals 1. If today’s price is higher,then RoC is greater than 1, and if today’s price is lower, then RoC is lessthan 1. The slope of the line that connects values for each day shows whether