Discussion 13 : Trend Following With Moving Average Convergence/Divergence (MACD)

Hello and a very good day to you! 

While viewing the charts that I have included in my previous Discussions, you guys might have seen some Momentum Indicators (MI) and Momentum Oscillators (MO) being plotted to enhance the reliability of signals generated. These Western technical tools are generally used to gauge the force behind a price trend or movement, and very often, are used to generate entry and exit signals for technical traders.

MOs, such as Stochastic and RSI, are leading indicators of a price movement. Oscillators would make use of two lines to gauge an overbought and oversold region. It is generally understood that one should sell when the price is in the overbought region, and buy when it is in the oversold region.

MIs, such as Moving Averages (MAs) and MACD, are lagging indicators. They will urge you to chase the boats that you have missed! Despite the fact that MIs often give signals late, causing you a late entry to an already established trend, it is many times more reliable than MOs, which are renowned for their high frequencies of emiting False Signals.


INTRODUCTION
Moving Average Convergence/Divergence (MACD) is a Momentum Indicator created by Gerald Apple in the late 1970s, and futher improved by Thomas Aspray in 1986. MACD, pronounced as "mack-dee" by technicians around the world, appears in chartists' toolbox as a deadly trend following indicator. It generates entry and exit signals for long term trend tradings, and is also often used to enhance reliability of signals generated by Candlestick Patterns.


SETUP OF MACD
MACD indicator is generally comprised of 3 components:

1. MACD Line - 12 days EMA of stock price minus 26 days EMA of stock price.
2. Signal Line - 9 days EMA of MACD Line.
3. MACD Histogram - Difference between MACD Line and Signal Line.

Note that in MACD, EMAs are used in favour of SMAs. Exponential Moving Averages (EMA) put a higher weighting on the more recent stock price against the older ones. This is essential due to the principle that the latest stock prices would logically 'spearhead' the upcoming/existing trend.


ZERO LINE CROSSOVERS
Principles:
Buy Signal - When MACD Line crosses over Zero Line from the bottom.
Sell Signal - When MACD Line crosses over Zero Line from the top.

The zero line acts as a 'realm divider' between an uptrend and a downtrend. According to the MACD, an uptrend is confirmed when the MACD Line crosses above the Zero line (positive region), and a downtrend is confirmed when the MACD Line drops below the Zero line (negative region). Illustration (i) shows FBMKLCI daily chart of year 2008 and year 2009, with the Zero Line and MACD Line clearly separating the two trends.

Illustration (i) : FBMKLCI - MACD & Identification of Trend

MACD Line takes the difference between a faster EMA (12 days) and a slower EMA (26 days). As the differences increase, the MACD Line will sway further away from the Zero Line, be it in positive or negative regions. As the differences decrease (happens when stock prices consolidate), the MACD Line moves closer to Zero Line. A crossover happens when there is a change in polarity from negative region to positive region, and vice versa (happens when consolidation is over, i.e. consolidation breakout!). See illustration (ii).

Illustration (ii) : FBMKLCI - MACD & Consolidation Breakout Play

However, caution should be taken while implementing this strategy. A Zero Line Crossover could happen in an instant due to a sudden change of price momentum from upwards to downwards, or vice versa. In that case, the crossover is no longer due to a consolidation breakout, and chasing such trend could be dangerous, as the trend might have already been exhausted by the time it crosses the Zero Line.


MACD CROSSOVERS (SINGLE LINE CROSSOVERS)
Principles:
Buy Signal - When MACD Line crosses over Signal Line from the bottom (Bullish MACD Crossover).
Sell Signal - When MACD Line crosses over Signal Line from the top (Bearish MACD Crossover).

Signal Line is the 9 day EMA of the MACD Line. This acts to 'smoothen' and 'average out' the MACD Line. As the MACD Line crosses over the Signal Line, it means a change in momentum is under way. Buy and sell decisions based on MACD Crossovers should therefore be more profitable, compared to Zero Line Crossovers, as MACD Crossovers give an indication of a change in momentum, which is a necessary build-up to a change of polarity.

Illustration (iii) shows how KFC fares using the MACD Crossover strategy.

Illustration (iii) : KFC - MACD Crossovers

Traders should be careful when practising this approach as it tends to give quite a number of False Signals, particularly when MACD Line and Signal Line braid themselves during short term consolidations. Traders should make use of other predictive indicators such as Candlestick Patterns, as they could give an early psychological indication of a potential momentum outbreak.


MACD HISTOGRAM
The improvement made by Thomas Aspray on the MACD system is the introduction of MACD Histogram. MACD Histogram measures the difference between the MACD Line and Signal Line and present them in the form of histogram.

Principle:
Buy Signal - MACD Histogram reduces in length and formed below the Zero Line.
Sell Signal - MACD Histogram reduces in length and formed above the Zero Line.

When MACD Crossovers give a buying or selling signal, they are very often a late entry and exit signal. This is due to the lagging nature of Moving Averages (which is the heart of MACD system). Thomas Aspray then came up with an idea that entries and exits should not be based on MACD Crossovers, but should be triggered when the differences between MACD Line and Signal Line reduce. That is the earliest possible entry and exit points that would yield maximum profits.

Compare illustration (iv) with illustration (iii). Both charts represent KFC in the same exact situation. See the differences in profits if MACD Histogram is heeded ahead of MACD Crossover!

Illustration (iv) : MACD Histogram



MACD DIVERGENCE
This is by far the most powerful signal that any MI or MO can give. A divergence means that the price actions (price movements) are inconsistent with signals generated from the MI or MO. Divergences occur in MACD as well.

The general rule for divergences in any MI or MO is, the price action would ultimately follow the direction signalled by the MI or MO.

Study OSK's daily chart in illustration (v) and see for yourself!

Illustration (v) : OSK - MACD Divergence

CONCLUSION
MACD is a useful indicator for intermediate term swing traders and position traders, as trend following is the core concept of this system.

Shorter term traders such as day traders and short term swing traders may make use of this indicator to confirm the direction of the prevalent trend, on multiple time-frame charts. Scalpers may want to scalp only in a long position on 5-minute chart if the MACD on hourly chart shows upwards momentum. The risk of losing is then highly minimized.

There are many further information and knowledge that revolves around this topic, which I couldn't finish discussing even with another 10 similar articles! MACD is a system that looks simple, but contains highly sophisticated trading disciplines that could greatly enhance trading precision and winning probabilities, particularly for a long term position trader.

The best way to learn a technique is to learn it from its creator. I highly recommend these 2 books for my readers who are interested in perfecting this technique. One of them is written by Gerald Appel in 1985, entitled "The Moving Average Convergence - Divergence Trading Method (Advanced Version)". Another would be "Understanding MACD", a book he co-authored with Edward Dobson in 2008. These 2 books, together with other MACD materials, are now available at TLSBookstore.com.

So, ride the trend for the week ahead with MACD! I'll see you again next week~! = )


The Moving Average Convergence-Divergence Trading Method (Advanced Version)

Discussion 12 : Head and Shoulders

Greetings! Made any profits last week? = )


INTRODUCTION
Head and Shoulders (H&S) is a chart pattern which is extremely reliable in identifying an end of an uptrend and gives birth to a new downtrend, and is very commonly seen on daily charts, as well as intra-day charts. The silhouette of H&S pattern resembles a human with one head and two shoulders.

The reverse of this chart pattern is known as Inverted Head and Shoulder Pattern (IH&S), which I regard as rather rare in KLSE, and is comparatively less reliable than H&S. IH&S is a bullish reversal chart pattern which is seen at the bottom of a downtrend.

The heart of Discussion 12 is H&S, which is a bearish reversal chart pattern.

CHART PATTERN OF HEAD AND SHOULDERS
H&S is basically identified by its pattern of having three consecutive tops, with the middle top higher than the tops on the left and right side. A neckline is drawn from the low of the retracement of the left top, to the low of the retracement of the middle top, projecting it further to gauge the retracement low of the right top. Refer illustration (i).

Illustration (i) : KNM - H&S and Neckline

BREAKING THE NECKLINE
The H&S pattern is complete when the price breaks the neckline on the right. Then, the stock price would have effectively fallen out of the prevalent trend. If the neckline at the right shoulder is not broken, then there is a possibility of it being a false signal. The high of the right shoulder should not be broken if the signal is to remain valid. After breaking the neckline, the neckline support now turns into neckline resistance. Refer illustration (ii).

Illustration (ii) : KNM - Breaking the Neckline

PREDICTIVE NATURE OF HEAD AND SHOULDERS PATTERN
The distance between the head and neckline would be taken as a guideline to gauge how far will the price drop after breaking the neckline. There is a rather complicated rationale behind this technique, which I would not explain further as at now. Having said so, I find that the gauge is rather accurate when practised in KLSE. Refer illustration (iii).

Illustration (iii) : KNM - Predictive Nature of H&S

THE ROLE OF VOLUME IN HEAD AND SHOULDERS PATTERN
Ideally, we would want to see higher volume on the build-up of the left shoulder (preferably a volume blowoff at the left shoulder top) compared to the build-up of the head. This means there are declining interests in the build-up towards the top of the head. The descent from the top of the right shoulder that breaks the neckline should be accompanied by increasing volume. Refer illustration (iv).

Illustration (iv) : KNM - Volume in H&S

OTHER CONFIRMATIONS
It is crucial that any TA techniques not to be used in isolation. Traders/technicians must seek confirmation(s) or convergence(s)/divergence(s) of other technical indicators to further enhance the signal emitted by any one indicator.

In explaining the the above theories, I have made use of KNM as an illustrative example. Keep in mind that you might have already seen this chart in Discussion 11 (Part 1) : Playing the Gap (Basic Hand). Aside from Gap Analysis and H&S Pattern, many other indicators can be used to further confirm this signal. For instance, Volume Analysis (as detailed above), Stochastic Divergence, and Moving Average. Refer illustration (v).

Illustration (v) : KNM - Stochastic Divergence / Moving Average Convergence

ANOTHER EXAMPLE
Please see the below chart for another illustration of H&S Pattern in WCT (illustration (vi)).

Illustration (vi) : WCT - Head and Shoulders Pattern

CONCLUSION
With the recent KLCI moving upwards after a few successive declines, it is imperative to deduce that the index is currently in a downward momentum. With this upward movement seen as a temporary pullback (in my opinion), I would be expecting to see more downward movements in the near future, and I mean real near future. >.<

I hope that by sharing this bearish reversal chart pattern would help serve my readers to as an early indication of any possible trend reversals that might unfold. Capital preservation is number one priority in stock trading. Therefore, remember,

"Cut your losses short, let your profits run!"

Happy trading for the coming week ahead~!   = )

Robert Kiyosaki's Talk on Financial IQ

Dear Readers,


Robert Kiyosaki is one of the investment gurus that I have always looked up to. I have learned a great deal of Personal Finance from his talks and best-selling books, "Rich Dad, Poor Dad" series. Up to today, I am still re-reading his books as if it is my 'Financial Bible'! = ) His knowledge would undeniably pave marble steps on the stairs to Financial Independence.

I came across this clip while surfing in Youtube and felt a sudden urge to share it with you. It was one of his talks on Financial IQ, in which he very quickly review the definition of assets and liabilities, and a brief discussion on the Cashflow Quadrant.

Ladies and gentlemen, I present to you, Mr Robert Kiyosaki!!

Discussion 11 (Part 2) : Playing the Gap (Professional Hand)

Hello there~!

KLCI took a beating last week as a result of most stock prices succumbed to series of bad news. We have seen China reporting its largest traded deficit in 7 years in February, crude oil price continuing its ascent due to growing unrest in Libya, contraction in Japan's 4Q2010 GDP, Moody's downgrade of Spain's government bonds rating, and also not forgetting the unfortunate natural calamity that hit Japan last Friday.

While all these adversely affect regional stock market, we as distinguished traders/investors know well that stock prices are now retreating to possible lows. For those who have lost a fortune last week, reflect on your losses, then wipe your tears right now! Opportunities tend to show itself during unexpectedly bad situations! Remember,

"From the ashes of defeat, burns the fire to success!"


INTRODUCTION

In Part 1, we have discussed on the basic strategies that most traders practise, which could be summarized as follows:

1. "Go (trade) in the direction of Window" (Window as Continuation Pattern)
2. Empty vacuum as Support & Resistance, confirmed by volume (Gap Breakout Play)

Western Technical Analysts enhanced the use of Windows (Gap, in Western term) by further classifying Gaps into four categories - Common, Breakaway, Runaway, and Exhaustion.


COMMON GAP (CG)
As the name suggests, CGs are commonly seen on charts. They often appear on shorter time frame charts, such as 1 and 5 minute charts, but may also appear on daily charts in numerous occassions. CG happened due to short temporary differences in pricing psychology, which don't really play a significant influence on the price trend.

Therefore, CGs usually appear together with low volume confirmation, and the vacuum area would be relatively smaller compared to other types of Gaps. Traders will expect that CGs would be filled rather quickly, perhaps within a few minutes (intra-day chart) or days (daily chart), before continuing the prevalent trend.


BREAKAWAY GAP (BG)
BG usually appears in two situations where:

1. A prevalent trend has been established, and the stock price has been moving along the trend, and hesitated at the top or the bottom.
2. The prevalent trend has ended, and the stock price has moved into a consolidation in a box range.

BG usually gives birth to a new trend. The term "Break-away" here means the trend has broken, and is now moving away from the prevalent trend. Usually BG will come together with high volume and has a significantly huge empty vacuum in between.

Traders will generally wait for the break to extend for a moment and will expect the stock price to make a retracement back to the Gap Support or Resistance. Only then, they will buy, or short stocks accordingly.

In KLSE, the probability of a downtrend BG to make a pull back to its resistance is a lot lower compared to an uptrend BG. This is because this retracement happens due to profit takings. As KLSE discourages shorting of stocks (policy wise), and if a downtrend BG were to occur, those caught in the wrong position will frantically sell to cut loss. This action will further increase the already strong downward force! Dumb Money (DM), in this sense, will start cannibalizing among themselves. >.<


RUNAWAY GAP (RG)
RG appears in the middle of an trend. Sometimes RG is called a Continuation Gap, which literally means a continuation of prevalent trend. A RG normally comes together with a huge volume and an empty vacuum usually smaller than BG, but bigger than a CG.

RG occurs due to renewed interests in the stock. This may happen following a reported increase/decrease in corporate earnings during a price uptrend/downtrend. Investors' confidence are greatly enhanced/reduced by this, causing the eventual Gap Up/Down.


EXHAUSTION GAP (EG)
EG usually shows itself at the end of the prevalent trend. EG comes with a small volume, and has a huge empty vacuum. The term "Exhaustion" here means that the prevalent trend is over-extended, and is currently exhausted. The trend has come to an end.

Having said so, traders should expect to see a sharp trend reversal after the new high/low is hit.


PUTTING IT ALL TOGETHER
Let's study AFFIN's chart between late October 2009 to mid April 2010.



Illustration (i) : Playing the Gap - AFFIN


At A, a Common Gap is seen, which has a small empty vacuum in between accompanied by low volume. It has an insignificant effect on the trend, and was therefore instinctively filled on the next day.

At B, we could see a Runaway Gap. Although the empty vacuum is small, the gap is formed after an uptrend is established. In addition to that, the volume that come together with the gap is not massive enough to be considered as a Breakaway Gap.

After two days, an Exhaustion Gap is seen at C. This is evidenced by a significantly massive volume, pushing the stock price up to a ridiculous high, causing the trend to over-extend. A very useful indicator to use while detecting overextended trends is the Bollinger Band. You can see that the White Candle at C is trading outside the Upper Bollinger Band, which is a very strong evidence that the trend had over-extended, which you would then expect a trend reversal to follow.

Soon, the price kissed the Gap Support twice, and then made a bounce to test the prior resistance made by the high at C. Failing to break through the resistance up north (as expected), the price then made its way south to break the Gap Support.

The supposedly downward trending technical outlook took a complete turn when the candles made a Breakaway Gap at D. This is a Breakaway Gap due to the high volume which accompanied the Gap Up. With the Gap unlikely to fill itself, the price went all the way up from mid December 2009 to mid April 2010, when the price again over-extended itself when it formed a White Candle outside of the Upper Bollinger Band.

Assuming that you took a long position after the Breakaway Gap on 14/12, and closed your position just after the confirmation on 12/04, you would have made a 31.3% profit in just a little under 4 months, which is already well above the average performance of most, if not all, mutual funds in Malaysia. All these profits could have been yours, if you have been competently playing well with the Gap. ^_^

CONCLUSION
The Window classifications made by Western traders are very useful indication of whether the Gap will fill itself or otherwise in near future, thereby allowing traders to position themselves for better entries. Below table shows a summary of the four Gaps.


Illustration (ii) : Summary - Type of Gaps


There is saying like this among Western Traders, "Gaps will be filled". Basing on this belief, many traders go against the Gap, hoping the Gap will be filled. Well, I have no idea how true this saying is. But as far as I'm concerned, I play the Gaps professionally, according to the strategies I've detailed above. I may not win all the time, but the probability of winning is greatly enhanced, and that's what Technical Analysis all about. :D


tlsinvestor.blogspot.com prays for the unfortunate victims of recent earthquake and tsunami in Japan. I urge all readers to join us for a moment of silence right now... May the streak of calamities end soon...

Discussion 11 (Part 1) : Playing the Gap (Basic Hand)

Coming from an accountancy background, it is only natural that most of my friends come from that field as well. However, being accountants and auditors don't necessarily mean that we possess above average financial knowledge. I had this conversation with my friend, who has read Discussion 9, and asked me this,

"How could Gaps happen? Isn't the opening balance of the next day equal to the closing of previous day?"

My response to her was,
"We are not preparing accounts!"

A few days later, another friend of mine asked me the same question after reading Discussion 9, and again, I told her the same thing. After hearing that, she exclaimed that investing is risky. Stock trading is risky. You could lose hundreds or thousands in just a morning due to a Gap. She then went on to close her mind on the subject matter.

I did not respond further. Sometimes, I feel that if I were to gather a group of 10 accountants or auditors, I will get 9 paradoxically formed animals. Like an eagle, they proudly perform risk assessments and majestically criticize others' risk management policies, but they immediately turned into a scaredy-cat when they assess and manage their own financial risks!

In fact, I very much agree with my friend on the risks that are present due to a Gap movement. However, rather than turning away from the stock market, I seek a way to bend that risk into a weapon of financial wealth! Let me now share with you some fundamental knowledge on how to play the Gap in our favour.


CONVERGING EASTERN AND WESTERN TERMINOLOGIES
In Japanese terminology, a Western "Gap" is called a "Window". In my Discussions, I will use Gaps and Windows interchangeably, as they essentially mean the same thing.

A Western "Gap Up", is a Japanese "Rising Window", while a Western "Gap Down", is a Japanese "Falling Window".


IDENTIFYING WINDOWS


Illustration (i) : Window

Windows are identified as an empty vacuum between two candlesticks. In other words, it means, there must be a 'gap' between the first candle's high/low and second candle's low/high.

Know that the key here is the candles' high and low, not the real body. If the shadows of the candles exist in the empty space, then there is no empty vacuum, and therefore, no Window. See illustration (i).


WINDOW AS A CONTINUATION PATTERN



Illustration (ii) : Rising & Falling Window

Most of the time, we see a Window as a continuation of the prevalent trend. As the Japanese saying goes, "Go in the direction of the Window". This is the very basic that you must have in mind when playing a gap.

If a Rising Window is formed in an uptrend, then traders/investors may seek to buy when the price takes a retracement. If a Falling Window is formed in a downtrend, then you may seek to sell when a rebound occurs. Refer illustration (ii).


WINDOW AS SUPPORT & RESISTANCE



Illustration (iii) : Support & Resistance Area

Japanese says, "Corrections stop at the Window". Windows act as a support or resistance of price movements.

In a Rising Window, the area between the low of the second candle and the high of the first candle would act as a support area, with the high of the first candle being he last line of support.

In a Falling Window, the area between the high of the second candle and the low of the first candle would act as a resistance area, with the low of the second candle being the last line of resistance.

The volume on the gapping day would serve to tell the strength of the resistance or support. Higher volume means stronger resistance or support, and vice versa.



Illustration (iv) : Gap Breakout Play

Traders may time for a breakout play this way. A breakout is usually confirmed by a close above the resistance or below a support. Merely having a shadow peeking above a resistance or below a support doesn't confirm that the resistance or support is broken. The general rule is to enter into the play after a breakout is confirmed, as seen in illustration (iv).

However, a handful of competent traders trade on breakout strategies during the formation of the candle itself. If there is a high volume during the intra-day, and the trader is confident that the price would close above the resistance or below the support, he may make an early entry to maximize profits.


PUTTING IT ALL TOGETHER
Let's study KNM. Refer Illustration (v).



Illustration (v) : Gap Analysis - KNM

Three Rising Windows (RW) are seen in KNM daily chart. Notice that in all three RW days, the volume is considerably enormous compared to others. This shows the strength of the support areas, as well as the strength of the trend.

An ideal entry would be after the retracement following the first RW on 06/12, when the price closes on the support of MA50d. Coincidently, that was the time when MA50d crosses over MA100d, giving a bullish signal as well. The stock price then rallied to make another two RW.

After the third RW, the stock retraced to test the support area of RM2.80 - RM 2.81, before making another higher low. A stop loss should be adjusted to just below the higher low, at approximately RM3.00. The reason for this is that in an uptrend, the stock price should make a higher high and a higher low. The trend was then broken on 21/01 when it is unable to make another higher low.

After tested the third RW's support area for a number of times, the support was finally broken on 23/02. The Bullish Counterattack Pattern wasn't good enough to sustain the support area, due to poor volume. On 24/02, the stock price plummetted down to the next support area formed on the previous RW, at RM2.34 - RM2.37.

On 03/03, a Bullish Hammer was formed at support area. Together with the black candle on 02/03, these two candles complete the Bullish Harami Pattern.

A RW was seen the next day on 04/03, with its lower shadow resting on its support of MA100d, accompanied by healthy volume. All these lead to a bullish signal, with the immediate resistance area of RM2.80 - RM2.81 (support turned resistance). This bullish attempt is confirmed to be a failure when the price closes below RM2.29 (the low of previous Bullish Hammer).


This concludes the first instalment of Playing the Gap. It is reminded that trading at the gap is arguably a risky strategy to trade. However, competent traders usually make use of more advanced strategies to ensure that their 'bet' at the gap has a higher winning probability. This, I will address in Discussion 11 (Part 2) : Playing the Gap (Professional Hand).

Happy trading on the fruitful week ahead!


[Disclaimer: The only reason I made use of KNM in this Discussion as my example is that it illustrates Gap Analysis closer to current date. It certainly does not constitute to a suggestion or recommendation to buy or sell KNM shares. >.<]