After
the August 2015 sell-off the broad-based indexes found support and pivoted
higher before month-end. However, by the latter half of September 2015 more
selling pressure came into the market pushing the price of the S&P 500
Index (SPX) down to a near retest of its August 2015 lows while moving the
value of the Russell 2000 Index (RUT) to new lows. Even though the price action of these two
indexes differed, the behavior of each respective Moving Average Convergence
Divergence (MACD) Indicator was the same. Specifically, both MACD’s formed a
higher low in late September 2015 after the August 2015 low was formed. Given the
aforementioned similarities, MACD conveyed a powerful underlying message. In
the case of RUT we observe that divergence formed between the lows of the price
and the lows of the MACD lines. That is, as RUT formed a lower-low by the end
of September 2015 its MACD was making a higher-low which is indicative of
future price strength. MACD is categorized as a trend indicator and drawing
trendlines between lows and highs of MACD can help identify the direction of a
price trend. Additionally, divergence between an index and its indicator is
often a reliable sign of an upcoming price move. In this case, after the
divergence, the price of RUT followed through to reach new multi-month highs by
year-end 2015. This divergence can be classified as bullish divergence since
after RUT and MACD formed a lower-low, MACD went on to make a higher-low (i.e.
bullish trend development) while RUT diverged by making a lower low. Alexander
Elder notes, “Bullish divergences occur toward the end of downtrends and often
precede sharp price rallies.” (The New Trading for a Living, pg. 86) A long
position could have been initiated when the Fast MACD (blue) line crossed above
its Slow Signal (red) line with a stop placed below the September 2015 lows in case
the price did not follow-through and move higher.
Bullish Divergence:
Conversely,
the pattern between SPX and its MACD during this same timeframe displays
confirmation. That is, as SPX and its MACD formed lows in late August 2015 both
made higher lows at the end of September 2015. Such confirmation has positive
implications for future price action and can be referred to as bullish
confirmation. As the name implies, MACD is merely confirming the price trend in
SPX and should add confidence in holding any existing position or, in this
case, identifying a reliable trade set up. A long position could have been
opened after the Fast MACD (blue) line crossed over the Slow Signal (red) line.
As always, a protective stop would need to be place below the most recent price
low.
Bullish Confirmation:
Charts are in arithmetic
scale
In the charts above, MACD is calculated in the conventional
manner as follows:
1) Calculate
the 12-day Exponential Moving Average (EMA) of prices.
2) Calculate
the 26-day EMA of prices.
3) Subtract
the 26-day EMA from the 12-day EMA and plot the differences as a blue line.
This is the Fast MACD line.
4) Calculate
the 9-day EMA of the fast line and plot the result as a red line. This is the Slow Signal line.
Source: Alexander Elder’s “New Trading for a Living”
JD
Comments
Post a Comment