Moving Average Convergence-Divergence (MACD)

By Marcus Fei

What is it?

Developed by Gerald Appel in the late 1970s, MACD is one of the most popular technical
indicators employed by short and long term traders and investors in virtually every financial
market today. MACD has also become a staple feature in every computer-based technical
trading program and platform.

The MACD value is essentially the difference of a short-term exponential moving average
minus a long-term moving average. Tracking the MACD value over time, we will be able to
plot a line, known as the MACD line, which fluctuates along a middle zero-value line where
the two moving averages meet. The MACD line will turn up when prices start to rise as the
short-term moving average will rise more quickly than the long-term moving average. The
MACD line will start to flatten or turn down when prices start to decline as the short-term
moving average will fall towards and possibly below the long-term moving average. As
prices move, the short-term moving average will move away (diverge) and move towards
(converge) the long-term moving average and hence the name moving average convergence-
divergence. An exponential moving average of the MACD line, which is known as the Signal
line, is normally plotted together with the MACD line and carries its own significance (which
will be explained below) when used in conjunction with the MACD line.

At TradeSignum.com, whenever MACD is selected, the default values are set at 12 periods
for the short-term moving average, 26 periods for the long-term moving average and 9
periods are used for the signal line. A histogram is plotted as well to provide a clearer picture
of the difference between the short-term and long-term moving averages.

What is it used for?

MACD is used generally used to provide buy and sell signals in the market and it has also
been used to assess strength of trends and provide early warnings of potential reversals.
How to use it?

The first set of signals generated by MACD is to buy when the MACD line crosses above the
zero-line from below and to sell when the MACD line crosses below the zero-line from
above. The second set of signals generated by MACD is to buy when the MACD line crosses
above the signal line from below and to sell when the MACD line crosses below the signal
line from above. The bullish example below shows a situation where the MACD line crosses
above the zero-line and signal line from below in the same instance and the bearish example
shows that they can occur individually.
Using MACD, we can also gauge the momentum of the current market
direction. When the momentum in a current market direction starts to fail,
positive and negative divergences can be spotted between the price and
the MACD levels. Positive divergence, a bullish indicator of a possible
market bottom, occurs when the price continues to drop to new lows while
the MACD line does not move in tandem and does not record new lows.
Negative divergence, a bearish indicator of a possible market top, occurs
when the price continues to climb higher to new highs while the MACD
line does not gain in tandem and fails to record new highs.
Examples below show a combination of MACD signals in effect.

Important supplementary Buy and Sell rules

According to Mr Appel, supplementing the basic buy and sell signals with the following
caveats will often produce more reliable signals.

• Buy signals are much more reliable when the MACD line has crossed below zero
from above at some time since the most recent sell signal. The MACD line does not
have to be below zero at the time of the buy signal but it should have been below zero
at some time since the recent decline.
• Sell signals are more reliable when the MACD line has crossed above zero from
below at some time since the most recent buy signal. The MACD line does not have
to be above zero at the time of the sell signal but it should have been above zero at
some time since the recent advance.
• During strong uptrend periods, typically during the early stages of bull markets, the
MACD will retreat during market reactions to a level just above zero instead of going
below zero. Like wise, in strong downtrends, MACD may top out just below zero
instead of crossing above. In such instances, we may ignore the zero crossing caveat,
otherwise, the zero crossing condition should be respected.
Using two MACD combinations

Mr Appel also recommends using at least two MACD combinations for buy and sell signals
and in different market environments.

In general, Mr Appel suggests using a faster (more sensitive) MACD for buying and a slower
(less sensitive) MACD for selling.

• In periods of strong uptrends, buy very fast and sell very slow. A 12-26, or even a
faster 6-19, MACD should be used for buying and a 19-39 MACD should be used for
selling.
• In periods of neutral to positive, buy fast and sell slow. A 12-26 MACD for buying
and a 19-39 for selling.
• In periods of clear downtrends, buy fast and sell fast. A 12-26 MACD is
recommended for buying and selling signals.

Example below illustrates how a faster 12-26 MACD can often provide a earlier entry point
and a slower 19-39 MACD can help to stay with profitable positions during a positive
markets and prevent premature exits.
Relative Strength Index (RSI)
By Marcus Fei

What is it?

Developed by J. Welles Wilder Jr., RSI was published in his 1978 classic "New Concepts in
Technical Trading Systems".

Essentially, RSI is a form of a smoothed momentum indicator. The term “relative strength” in
this case is sometimes considered as a misnomer as RSI is not used to compare between two
different instruments as the term “relative strength” would normally indicate. RSI’s formula
takes into the consideration of the average closes of X number of up days and the average
closes of X number of down days to determine a momentum number that ranges between 0
and 100. Plotted over time, RSI would resemble a line that fluctuations between 0 and 100.

At TradeSignum.com, whenever RSI is selected, the default value of 14-periods is selected.

What is it used for?

RSI is popularly used to identify potential buy and sell situations through overbought and
oversold situations. It can be used to spot potential trend reversals through positive and
negative divergences as well as the breaking of its own trendlines.

How to use it?

The first use of RSI is to determine overbought and oversold levels. Generally, it is
considered to be oversold when RSI dips below 30 and overbought when RSI crosses above
70. However, in strong trending periods, RSI may stay overbought/oversold for an extended
period of time and as such buy signals are only given when RSI crosses back above the 30
line from below and sell signals are given only when RSI crosses below the 70 line from
above. It has also been suggested overbought/oversold signals are more reliable under range
trading than non-trending periods.

Overbought and Oversold Signals

Using RSI, we can also gauge the momentum of a current market direction. When
momentums in current market directions start to fail, positive and negative divergences can
be spotted across the price and RSI levels. Such divergences are also known as "Failure
swings". A bottom failure swing is a bullish indicator of a possible market bottom, occurs
when the price continue to drop to new lows while RSI does not move in tandem and does
not record new lows. A top failure swing is a bearish indicator of a possible market top,
occurs when prices continue to climb higher to new highs while RSI does not gain in tandem
and fails to record new highs. Wilder considers divergences between RSI and then price line
when RSI is below 30 or above 70 as the single most indicative characteristic of the RSI and
should be considered as a serious warning whenever spotted.

Bottome Failure Swing Top Failure Swing

Trendlines can also be used in conjunction with the RSI line. A buy signal is given when RSI
breaks above its downward trendline and a sell signal is given when RSI breaks below its
upward sloping trendline.
 RSI Trendlines

Conclusion

Depending on your style of trading, whether you are a momentum trader or range trader, RSI
can help you identify better trading decisions. As with other technical systems, RSI has its
strengths and weaknesses and will perform well in one market environment and may not do
so well in another. Hence understanding when to RSI and how to use it in conjunction with
other technical indicators will most definitely help us to determine more profitable trades.
Introduction to Japanese Candlesticks
By Marcus Fei

Japanese have relied on candlesticks for centuries but it is only very recently that Japanese
candlesticks have become popular with the Western world. Candlesticks use the exact same
data that a bar chart would, i.e. open, high, low, close, only candlesticks are much more
appealing to the eye.

Candlesticks typically would have a real body and upper and lower shadows signifying where
the prices have traveled in the course of the period and whether the price ended higher or
lower at the close. A typical candlestick on an up day would have a green (or white) body
while a candlestick on a down day would have a red (or black) body. A strong up or down
day would leave a long real body where a weak up or down day would register a small real
body. Small real body candlesticks are also known as Spinning Tops which often represents
indecision in the market.

Candlesticks do not necessarily have to have a real body and/or upper or lower shadows. If a
price did not move at all throughout the entire period, a candlestick would just register a
horizontal bar which can also be called as a doji. Doji can come in a few different forms. The
primary characteristic of dojis is that dojis do not have a real body. Dojis, like Spinning Tops,
often suggests indecisions in the market. Dojis with long upper and lower shadows are also
known as High Wave candles and they often suggest that neither the bears nor the bulls have
the upper hand. Dojis with long lower shadow and no upper shadow is known as the
Dragonfly doji and is often indicative of potential buying pressure and support. Dojis with
long upper shadow and no lower shadow is known as the Gravestone doji and is often
indicative of potential selling pressure and resistance.

Individually, candlesticks can often provide significant suggestions as to what kind of market
psychology is driving the market. Combining several candlesticks can further create
candlestick patterns that can provide suggestions of potential market reversals as well as
continuations.

Bullish reversal patterns are candlestick patterns that can be spotted in a downtrend where as
bearish reversal patterns are candlestick patterns that can spotted in an uptrend. The key
criterion for the candlestick pattern to be valid is often the presence of the immediate
preceding trend. Bullish and bearish continuation candlestick patterns can also be spotted
during uptrends and downtrends and can potentially assist the trader in deciding whether to
enter a trade, exit a trade or to remain in a trade.

Below is a basic collection of some of the more recognisable candlestick patterns grouped
according to the signals they indicate.

Bullish Reversals
Bullish Continuation
Bearish Reversals
Bearish Continuation
Candlesticks and candlestick patterns can be an effective tool in studying the psychology of
the market participants and are essential in making market timing decisions. However,
candlesticks themselves do not offer time and price targets and should always be used in
conjunction with other technical tools and techniques to obtain better trading results.