OSCILLATOR USAGE IN CONJUNCTION WITH TREND

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OSCILLATOR USAGE IN CONJUNCTION WITH TREND

The oscillator is only a secondary indicator in the sense that it must be subordinated to basic trend analysis. As we go through the various types of oscillators used by technicians, the importance of trading in the direction of the overriding market trend will be constantly stressed. The reader should also be aware that there are times when oscillators are more useful than at others. For example, near the beginning of important moves, oscillator analysis isn’t that helpful and can even be misleading. Toward the end of market moves, however, oscillators become extremely valuable. We’ll address these points as we go along. Finally, no study of market extremes would be complete without a discussion of Contrary Opinion. We’ll talk about the role of the contrarian philosophy and how it can be incorporated into market analysis and trading.

Interpretation of Oscillators

While there are many different ways to construct momentum oscillators, the actual interpretation differs very little from one technique to another. Most oscillators look very much alike. They are plotted along the bottom of the price chart and resemble a flat horizontal band. The oscillator band is basically flat while prices may be trading up, down, or sideways. However, the peaks and troughs in the oscillator coincide with the peaks and troughs on the price chart. Some oscillators have a midpoint value that divides the horizontal range into two halves, an upper and a lower. Depending on the formula used, this midpoint line is usually a zero line. Some oscillators also have upper and lower boundaries ranging from 0 to 100.

General Rules for Interpretation

As a general rule, when the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may have gone too far too fast and is due for a correction or consolidation of some type. As another general rule, the trader should be buying when the oscillator line is in the lower end of the band and selling in the upper end. The crossing of the midpoint line is often used to generate buy and sell signals. We’ll see how these general rules are applied as we deal with the various types of oscillators.

The Three Most Important Uses for the Oscillator

There are three situations when the oscillator is most useful. You’ll see that these three situations are common to most types of oscillators that are used.

• 1. The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its boundaries. The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. This warns that the price trend is overextended and vulnerable.
• 2. A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.
• 3. The crossing of the zero (or midpoint) line can give important trading signals in the direction of the price trend.

Figure 10.1a The 10 day momentum line fluctuates around a zero line. Readings too far above the zero line are overbought, while values too far below the line are oversold. Momentum should be used in conjunction with the trend of the market.

MEASURING MOMENTUM

The concept of momentum is the most basic application of oscillator analysis. Momentum measures the velocity of price changes as opposed to the actual price levels themselves. Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10 day momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line. The formula for momentum is:

M=V – V x

where V is the latest closing price and V x is the closing price x days ago.

Figure 10.1b A comparison of 10 and 40 day momentum lines. The longer version is more helpful in catching major market turns (see circles).

If the latest closing price is greater than that of 10 days ago (in other words, prices have moved higher), then a positive value would be plotted above the zero line. If the latest close is below the close 10 days earlier (prices have declined), then a negative value is plotted below the zero line.

While the 10 day momentum is a commonly used time period for reasons discussed later, any time period can be employed. (See Figure 10.1a.) A shorter time period (such as 5 days) produces a more sensitive line with more pronounced oscillations. A longer number of days (such as 40 days) results in a much smoother line in which the oscillator swings are less volatile. (See Figure 10.1b.)

Momentum Measures Rates of Ascent or Descent

Let’s talk a bit more about just what this momentum indicator is measuring. By plotting price differences for a set period of time, the chartist is studying rates of ascent or descent. If prices are rising and the momentum line is above the zero line and rising, this means the uptrend is accelerating. If the upslanting momentum line begins to flatten out, this means that the new gains being achieved by the latest closes are the same as the gains 10 days earlier. While prices may still be advancing, the rate of ascent (or the velocity) has

leveled off. When the momentum line begins to drop toward the zero line, the uptrend in prices is still in force, but at a decelerating rate. The uptrend is losing momentum.

When the momentum line moves below the zero line, the latest 10 day close is now under the close of 10 days ago and a near term downtrend is in effect. (And, incidentally, the 10 day moving average also has begun to decline.) As momentum continues to drop farther below the zero line, the downtrend gains momentum. Only when the line begins to advance again does the analyst know that the downtrend is decelerating.

It’s important to remember that momentum measures the differences between prices at two time intervals. In order for the line to advance, the price gains for the last day’s close must be greater than the gains of 10 days ago. If prices advance by only the same amount as 10 days ago, the momentum line will be flat. If the last price gain is less than that of 10 days ago, the momentum line begins to decline even though prices are still rising. This is how the momentum line measures the acceleration or deceleration in the current advance or decline in the price trend.

The Momentum Line Leads the Price Action

Because of the way it is constructed, the momentum line is always a step ahead of the price movement. It leads the advance or decline in prices, then levels off while the current price trend is still in effect. It then begins to move in the opposite direction as prices begin to level off.

The Crossing of the Zero Line as a Trading Signal

The momentum chart has a zero line. Many technicians use the crossing of the zero line to generate buy and sell signals. A crossing above the zero line would be a buy signal, and a crossing below the zero line, a sell signal. It should be stressed here again, however, that basic trend analysis is still the overriding consideration. Oscillator analysis should not be used as an excuse to trade against the prevailing market trend. Buy positions should only be taken on crossings above the zero line if the market trend is up. Short positions should be taken on crossings below the zero line only if the price trend is down. (See Figures 10.2a and b.)

Figure 10.2a The trendlines on the momentum chart are broken sooner than those on the price chart. The value of the momentum indicator is that it turns sooner than the market itself, making it a leading indicator.

Figure 10.2b Some traders regard a crossing above the zero line as a buy signal and a crossing below the line as a sell signal (see circles). A moving average is helpful to confirm trend changes. The momentum line peaked before the price (see arrows).

The Need for an Upper and Lower Boundary

One problem with the momentum line, as it is described here, is the absence of a fixed upper and lower boundary. It was stated earlier that one of the major values of oscillator analysis is being able to determine when markets are in extreme areas. But, how high is too high and how low is too low on the momentum line? The simplest way to solve this problem is by visual inspection. Check the back history of the momentum line on the chart and draw horizontal lines along its upper and lower boundaries. These lines will have to be adjusted periodically, especially after important trend changes have occurred. But it is the simplest and probably the most effective way of identifying the outer extremities. (See Figures 10.3 and 10.4.)

Figure 10.3 By visual inspection, the analyst can find the upper and lower momentum boundaries that are suitable for each market (see horizontal lines).

Figure 10.4 A 13 week momentum line on a weekly chart of Treasury Bonds. The arrows mark the turning points from momentum extremes. The momentum line changed direction before the price at each major turn (points 1, 2, and 3).

MEASURING RATE OF CHANGE (ROC)

To measure the rate of change, a ratio is constructed of the most recent closing price to a price a certain number of days in the past. To construct a 10 day rate of change oscillator, the latest closing price is divided by the close 10 days ago. The formula is as follows:

Rate of change=100 (V/Vx)

where V is the latest close and Vx is the closing price x days ago.

In this case, the 100 line becomes the midpoint line. If the latest price is higher than the price 10 days ago (prices are rising), the resulting rate of change value will be above 100. If the last close is below 10 days ago, the ratio would be below 100. (Charting software sometimes uses variations of the preceding formulas for momentum and rate of change. While the construction techniques may vary, the interpretation remains the same.)

CONSTRUCTING AN OSCILLATOR USING TWO MOVING AVERAGES

Chapter 9 discussed two moving averages being used to generate buy and sell

signals. The crossing of the shorter average above or below the longer average registered buy and sell signals, respectively. It was mentioned at that time that these dual moving average combinations could also be used to construct oscillator charts. This can be done by plotting the difference between the two averages as a histogram. These histogram bars appear as a plus or minus value around a centered zero line. This type of oscillator has three uses:

• 1. To help spot divergences.
• 2. To help identify short term variations from the long term trend, when the shorter average moves too far above or below the longer average.
• 3. To pinpoint the crossings of the two moving averages, which occur when the oscillator crosses the zero line.

The shorter average is divided by the longer. In both cases, however, the shorter average oscillates around the longer average, which is in effect the zero line. If the shorter average is above the longer, the oscillator would be positive. A negative reading would be present if the shorter average were under the longer. (See Figures 10.5-10.7.)

When the two moving average lines move too far apart, a market extreme is created calling for a pause in the trend. (See Figure 10.6.) Very often, the trend remains stalled until the shorter average line moves back to the longer. When the shorter line approaches the longer, a critical point is reached. In an uptrend, for example, the shorter line dips back to the longer average, but should bounce off it. This usually represents an ideal buying area. It’s much like the testing of an up trendline. If the shorter average crosses below the longer average, however, a trend reversal is signaled.

Figure 10.5 The histogram lines measure the difference between the two moving averages. Crossing above and below the zero line give buy and sell signals (see arrows). Notice that the histogram turns well before the actual signals (see circles).

Figure 10.6 A histogram measuring the difference between the 10 and 50 day averages. The histogram always turns well before the zero line crossover. In an uptrend, the histogram will find support at the zero line and turn up again (third arrow).

In a downtrend, a rise in the shorter average to the longer usually represents an ideal selling area unless the longer line is crossed, in which case a trend reversal signal would be registered. The relationships between the two averages can be used, therefore, not only as an excellent trend-following system, but also to help identify short term overbought and oversold conditions.

Figure 10.7 A histogram plotting the difference between 2 weekly averages. The histogram turned in the direction of the new price trend weeks before the actual zero line crossings on the histogram. Notice how easily the overbought and oversold levels are seen.

COMMODITY CHANNEL INDEX

It is possible to normalize an oscillator by dividing the values by a constant divisor. In the construction of his Commodity Channel Index (CCI), Donald R. Lambert compares the current price with a moving average over a selected time span—usually 20 days. He then normalizes the oscillator values by using a divisor based on mean deviation. As a result, the CCI fluctuates in a constant range from +100 on the upside to -100 on the downside. Lambert recommended long positions in those markets with values over +100. Markets with CCI values below -100 were candidates for short sales.

It seems, however, that most chartists use CCI simply as an overbought/oversold oscillator. Used in that fashion readings over +100 are considered overbought and under -100 are oversold. While the Commodity Channel Index was originally developed for commodities, it is also used for trading stock index futures and options like the S&P 100 (OEX). Although 20 days is the common default value for CCI, the user can vary the number to adjust its sensitivity. (See Figures 10.8 and 10.9.)

Figure 10.8 A 20 day Commodity Channel Index. The original intent of this indicator was to buy moves above +100 and sell moves below -100 as shown here.

Figure 10.9 The Commodity Channel Index can be used for stock indexes like this one and can also be used like any other oscillator to measure market extremes. Notice that the CCI turns before prices at each top and bottom. The default length is 20 days.

THE RELATIVE STRENGTH INDEX (RSI)

The RSI was developed by J. Welles Wilder, Jr. and presented in his 1978 book, New Concepts in Technical Trading Systems. We’re only going to cover the main points here. A reading of the original work by Wilder himself is recommended for a more in-depth treatment. Because this particular oscillator is so popular among traders, we’ll use it to demonstrate most of the principles of oscillator analysis.

As Wilder points out, one of the two major problems in constructing a momentum line (using price differences) is the erratic movement often caused by sharp changes in the values being dropped off. A sharp advance or a decline 10 days ago (in the case of a 10 day momentum line) can cause sudden shifts in the momentum line even if the current prices show little change. Some smoothing is therefore necessary to minimize these distortions. The second problem is that there is the need for a constant range for comparison purposes. The RSI formula not only provides the necessary smoothing, but also solves the latter problem by creating a constant vertical range of 0 to 100.

The term “relative strength,” incidentally, is a misnomer and often

causes confusion among those more familiar with that term as it is used in stock market analysis. Relative strength generally means a ratio line comparing two different entities. A ratio of a stock or industry group to the S&P 500 Index is one way of gauging the relative strength of different stocks or industry groups against one objective benchmark. We’ll show you later in the book how useful relative strength or ratio analysis can be. Wilder’s Relative Strength Index doesn’t really measure the relative strength between different entities and, in that sense, the name is somewhat misleading. The RSI, however, does solve the problem of erratic movement and the need for a constant upper and lower boundary. The actual formula is calculated as follows:

Fourteen days are used in the calculation; 14 weeks are used for weekly charts. To find the average up value, add the total points gained on up days during the 14 days and divide that total by 14. To find the average down value, add the total number of points lost during the down days and divide that total by 14. Relative strength (RS) is then determined by dividing the up average by the down average. That RS value is then inserted into the formula for RSI. The number of days can be varied by simply changing the value of x.

Wilder originally employed a 14 day period. The shorter the time period, the more sensitive the oscillator becomes and the wider its amplitude. RSI works best when its fluctuations reach the upper and lower extremes. Therefore, if the user is trading on a very short term basis and wants the oscillator swings to be more pronounced, the time period can be shortened. The time period is lengthened to make the oscillator smoother and narrower in amplitude. The amplitude in the 9 day oscillator is therefore greater than the original 14 day. While 9 and 14 day spans are the most common values used, technicians experiment with other periods. Some use shorter lengths, such as 5 or 7 days, to increase the volatility of the RSI line. Others use 21 or 28 days to smooth out the RSI signals. (See Figures 10.10 and 10.11.)

Figure 10.10 The 14 day Relative Strength Index becomes overbought over 70 and oversold below 30. This chart shows the S&P 100 being oversold in October and overbought during February.

Figure 10.11 The amplitude of the RSI line can be widened by shortening the time period. Notice that the 7 day RSI reaches the outer extremes more frequently than the 14 day RSI. That makes the 7 day RSI more useful to short term traders.

Interpreting RSI

RSI is plotted on a vertical scale of 0 to 100. Movements above 70 are considered overbought, while an oversold condition would be a move under 30. Because of shifting that takes place in bull and bear markets, the 80 level usually becomes the overbought level in bull markets and the 20 level the oversold level in bear markets.

“Failure swings,” as Wilder calls them, occur when the RSI is above 70 or under 30. A top failure swing occurs when a peak in the RSI (over 70) fails to exceed a previous peak in an uptrend, followed by a downside break of a previous trough. A bottom failure swing occurs when the RSI is in a downtrend (under 30), fails to set a new low, and then proceeds to exceed a previous peak. (See Figures 10.12a-b.)

Figure 10.12a A bottom failure swing in the RSI line. The second RSI trough (point 2) is higher than the first (point 1) while it is below 30 and prices are still falling. The upside penetration of the RSI peak (point 3) signals a bottom.

Figure 10.12b A top failure swing. The second peak (2) is lower than the first (1) while the RSI line is over 70 and prices are still rallying. The break by the RSI line below the middle trough (point 3) signals the top.

Divergence between the RSI and the price line, when the RSI is above 70 or below 30, is a serious warning that should be heeded. Wilder himself considers divergence “the single most indicative characteristic of the Relative Strength Index” [Wilder, p. 70].

Trendline analysis can be employed to detect changes in the trend of the RSI. Moving averages can also be used for the same purpose. (See Figure 10.13.)

Figure 10.13 Trendlines work very effectively on the RSI line. The breaking of the two RSI trendlines gave timely buy and sell signals on this chart (see arrows).

In my own personal experience with the RSI oscillator, its greatest value lies in failure swings or divergences that occur when the RSI is over 70 or under 30. Let’s clarify another important point on the use of oscillators. Any strong trend, either up or down, usually produces an extreme oscillator reading before too long. In such cases, claims that a market is overbought or oversold are usually premature and can lead to an early exit from a profitable trend. In strong uptrends, overbought markets can stay overbought for some time. Just because the oscillator has moved into the upper region is not reason enough to liquidate a long position (or, even worse, short into the strong uptrend).

The first move into the overbought or oversold region is usually just a warning. The signal to pay close attention to is the second move by the oscillator into the danger zone. If the second move fails to confirm the price move into new highs or new lows (forming a double top or bottom on the oscillator), a possible divergence exists. At that point, some defensive action can be taken to protect existing positions. If the oscillator moves in the opposite direction, breaking a previous high or low, then a divergence or failure swing is confirmed.

The 50 level is the RSI midpoint value, and will often act as support during pullbacks and resistance during bounces. Some traders treat RSI crossings above and below the 50 level as buying and selling signals

respectively.

USING THE 70 AND 30 LINES TO GENERATE SIGNALS

Horizontal lines appear on the oscillator chart at the 70 and 30 values. Traders often use those lines to generate buy and sell signals. We already know that a move under 30 warns of an oversold condition. Suppose the trader thinks a market is about to bottom and is looking for a buying opportunity. He or she watches the oscillator dip under 30. Some type of divergence or double bottom may develop in the oscillator in that oversold region. A crossing back above the 30 line at that point is taken by many traders as a confirmation that the trend in the oscillator has turned up. Accordingly, in an overbought market, a crossing back under the 70 line can often be used as a sell signal. (See Figure 10.14.)

Figure 10.14 The RSI oscillator can be used on monthly charts. Notice the two major oversold buy signals in 1974 and 1994. The overbought peaks in the RSI line did a pretty good job of pinpointing important tops in the utilities.

STOCHASTICS (K%D)

The Stochastic oscillator was popularized by George Lane (president of

Investment Educators, Inc., Watseka, IL). It is based on the observation that as prices increase, closing prices tend to be closer to the upper end of the price range. Conversely, in downtrends, the closing price tends to be near the lower end of the range. Two lines are used in the Stochastic Process—the %K line and the %D line. The %D line is the more important and is the one that provides the major signals.

The intent is to determine where the most recent closing price is in relation to the price range for a chosen time period. Fourteen is the most common period used for this oscillator. To determine the K line, which is the more sensitive of the two, the formula is:

%K=100 [(C - L14) / (H14 - L14)]

where C is the latest close, L14 is the lowest low for the last 14 periods, and H14 is the highest high for the same 14 periods (14 periods can refer to days, weeks, or months).

The formula simply measures, on a percentage basis of 0 to 100, where the closing price is in relation to the total price range for a selected time period. A very high reading (over 80) would put the closing price near the top of the range, while a low reading (under 20) near the bottom of the range.

The second line (%D) is a 3 period moving average of the %K line. This formula produces a version called fast stochastics. By taking another 3 period average of %D, a smoother version called slow stochastics is computed. Most traders use the slow stochastics because of its more reliable signals.*

These formulas produce two lines that oscillate between a vertical scale from 0 to 100. The K line is a faster line, while the D line is a slower line. The major signal to watch for is a divergence between the D line and the price of the underlying market when the D line is in an overbought or oversold area. The upper and lower extremes are the 80 and 20 values. (See Figure 10.15.)

A bearish divergence occurs when the D line is over 80 and forms two declining peaks while prices continue to move higher. A bullish divergence is present when the D line is under 20 and forms two rising bottoms while prices continue to move lower. Assuming all of these factors are in place, the actual buy or sell signal is triggered when the faster K line crosses the slower D line.

There are other refinements in the use of Stochastics, but this explanation covers the more essential points. Despite the higher level of sophistication, the basic oscillator interpretation remains the same. An alert or set-up is present when the %D line is in an extreme area and diverging from the price action. The actual signal takes place when the D line is crossed by the faster K line.

The Stochastic oscillator can be used on weekly and monthly charts for longer range perspective. It can also be used effectively on intraday charts for shorter term trading. (See Figure 10.16.)

One way to combine daily and weekly stochastics is to use weekly signals to determine market direction and daily signals for timing. It’s also a good idea to combine stochastics with RSI. (See Figure 10.17.)

Figure 10.15 The down arrows show two sell signals which occur when the faster %K line crosses below the slower %D line from above the 80 level. The %K line crossing above the %D line below 20 is a buy signal (up arrow).

Figure 10.16 Turns in the 14 week stochastics from above 80 and below 20 did a nice job of anticipating major turns in the Treasury Bond market. Stochastics charts can be constructed for 14 days, 14 weeks, or 14 months.

Figure 10.17 A comparison of the 14 week RSI and stochastics. The RSI line is less volatile and reaches extremes less frequently than stochastics. The best signals occur when both oscillators are in overbought or oversold territory.

LARRY WILLIAMS %R

Larry Williams %R is based on a similar concept of measuring the latest close in relation to its price range over a given number of days. Today’s close is subtracted from the price high of the range for a given number of days and that difference is divided by the total range for the same period. The concepts already discussed for oscillator interpretation are applied to %R as well, with the main factors being the presence of divergences in overbought or oversold areas. (See Figure 10.18.) Since %R is subtracted from the high, it looks like an upside down stochastics. To correct that, charting packages plot an inverted version of %R.

Figure 10.18 Larry Williams %R oscillator is used in the same fashion as other oscillators. Readings over 80 or under 20 identify market extremes.

Choice of Time Period Tied to Cycles

Oscillator lengths can be tied to underlying market cycles. A time period of 1/2 the cycle length is used. Popular time inputs are 5, 10, and 20 days based on calendar day periods of 14, 28, and 56 days. Wilder’s RSI uses 14 days, which is half of 28. In the previous chapter, we discussed some reasons why the numbers 5, 10, and 20 keep cropping up in moving average and oscillator formulations, so we won’t repeat them here. Suffice it to mention here that 28 calendar days (20 trading days) represent an important dominant monthly trading cycle and that the other numbers are related harmonically to that monthly cycle. The popularity of the 10 day momentum and the 14 day RSI lengths are based largely on the 28 day trading cycle and measure 1/2 of the value of that dominant trading cycle. We’ll come back to the importance of cycles in Chapter 14.

THE IMPORTANCE OF TREND

In this chapter, we’ve discussed the use of the oscillator in market analysis to help determine near term overbought and oversold conditions, and to alert traders to possible divergences. We started with the momentum line. We discussed another way to measure rates of change (ROC) by using price ratios instead of differences. We then showed how two moving averages could be

compared to spot short term extremes and crossovers. Finally, we looked at RSI and Stochastics and considered how oscillators should be synchronized with cycles.

Divergence analysis provides us with the oscillator’s greatest value. However, the reader is cautioned against placing too much importance on divergence analysis to the point where basic trend analysis is either ignored or overlooked. Most oscillator buy signals work best in uptrends and oscillator sell signals are most profitable in downtrends. The place to start your market analysis is always by determining the general trend of the market. If the trend is up, then a buying strategy is called for. Oscillators can then be used to help time market entry. Buy when the market is oversold in an uptrend. Sell short when the market is overbought in a downtrend. Or, buy when the momentum oscillator crosses back above the zero line when the major trend is bullish and sell a crossing under the zero line in a bear market.

The importance of trading in the direction of the major trend cannot be overstated. The danger in placing too much importance on oscillators by themselves is the temptation to use divergence as an excuse to initiate trades contrary to the general trend. This action generally proves a costly and painful exercise. The oscillator, as useful as it is, is just one tool among many others and must always be used as an aid, not a substitute, for basic trend analysis.

WHEN OSCILLATORS ARE MOST USEFUL

There are times when oscillators are more useful than at others. During choppy market periods, as prices move sideways for several weeks or months, oscillators track the price movement very closely. The peaks and troughs on the price chart coincide almost exactly with the peaks and troughs on the oscillator. Because both price and oscillator are moving sideways, they look very much alike. At some point, however, a price breakout occurs and a new uptrend or downtrend begins. By its very nature, the oscillator is already in an extreme position just as the breakout is taking place. If the breakout is to the upside, the oscillator is already overbought. An oversold reading usually accompanies a downside breakout. The trader is faced with a dilemma. Should he or she buy the bullish breakout in the face of an overbought oscillator reading? Should the downside breakout be sold into an oversold market?

In such cases, the oscillator is best ignored for the time being and the position taken. The reason for this is that in the early stages of a new trend, following an important breakout, oscillators often reach extremes very quickly and stay there for awhile. Basic trend analysis should be the main consideration at such times, with oscillators given a lesser role. Later on, as the trend begins to mature, the oscillator should be given greater weight. (We’ll see in Chapter 13, that the fifth and final wave in Elliott Wave analysis is often confirmed by bearish oscillator divergences.) Many dynamic bull moves have been missed by traders who saw the major trend signal, but decided to wait for their oscillators to move into an oversold condition before buying. To summarize, give less attention to the oscillator in the early stages of an important move, but pay close attention to its signals as the move reaches maturity.

MOVING AVERAGE CONVERGENCE/DIVERGENCE (MACD)

We mentioned in the previous chapter an oscillator technique that uses 2 exponential moving averages and here it is. The Moving Average Convergence/Divergence indicator, or simply MACD, was developed by Gerald Appel. What makes this indicator so useful is that it combines some of the oscillator principles we’ve already explained with a dual moving average crossover approach. You’ll see only two lines on your computer screen although three lines are actually used in its calculation. The faster line (called the MACD line) is the difference between two exponentially smoothed moving averages of closing prices (usually the last 12 and 26 days or weeks). The slower line (called the signal line) is usually a 9 period exponentially smoothed average of the MACD line. Appel originally recommended one set of numbers for buy signals and another for sell signals. Most traders, however, utilize the default values of 12, 26, and 9 in all instances. That would include daily and weekly values. (See Figure 10.19a.)

The actual buy and sell signals are given when the two lines cross. A crossing by the faster MACD line above the slower signal line is a buy signal. A crossing by the faster line below the slower is a sell signal. In that sense, MACD resembles a dual moving average crossover method. However, the MACD values also fluctuate above and below a zero line. That’s where it begins to resemble an oscillator. An overbought condition is present when the lines are too far above the zero line. An oversold condition is present when the lines are too far below the zero line. The best buy signals are given when prices are well below the zero line (oversold). Crossings above and below the zero line are another way to generate buy and sell signals respectively, similar to the momentum technique we discussed previously.

Figure 10.19a The Moving Average Convergence Divergence system shows two lines. A signal is given when the faster MACD line crosses the slower signal line. The arrows show five trading signals on this chart of the Nasdaq Composite Index.

Divergences appear between the trend of the MACD lines and the price line. A negative, or bearish, divergence exists when the MACD lines are well above the zero line (overbought) and start to weaken while prices continue to trend higher. That is often a warning of a market top. A positive, or bullish, divergence exists when the MACD lines are well below the zero line (oversold) and start to move up ahead of the price line. That is often an early sign of a market bottom. Simple trendlines can be drawn on the MACD lines to help identify important trend changes. (See Figure 10.19b.)

Figure 10.19b The MACD lines fluctuate around a zero line, giving it the quality of an oscillator. The best buy signals occur below the zero line. The best sell signals come from above. Notice the negative divergence given in October (see down arrow).

MACD HISTOGRAM

We showed you earlier in the chapter how a histogram could be constructed that plots the difference between two moving average lines. Using that same technique, the two MACD lines can be turned into an MACD histogram. The histogram consists of vertical bars that show the difference between the two MACD lines. The histogram has a zero line of its own. When the MACD lines are in positive alignment (faster line over the slower), the histogram is above its zero line. Crossings by the histogram above and below its zero line coincide with actual MACD crossover buy and sell signals.

The real value of the histogram is spotting when the spread between the two lines is widening or narrowing. When the histogram is over its zero line (positive) but starts to fall toward the zero line, the uptrend is weakening. Conversely, when the histogram is below its zero line (negative) and starts to move upward toward the zero line, the downtrend is losing its momentum. Although no actual buy or sell signal is given until the histogram crosses its zero line, the histogram turns provide earlier warnings that the current trend is losing momentum. Turns in the histogram back toward the zero line always precede the actual crossover signals. Histogram turns are best used for

spotting early exit signals from existing positions. It’s much more dangerous to use the histogram turns as an excuse to initiate new positions against the prevailing trend. (See Figure 10.20a.)

Figure 10.20a The MACD histogram plots the difference between the two MACD lines. Signals are given on the zero line crossings. Notice that the histogram turns earlier than the crossover signals, giving the trader some advanced warning.

COMBINE WEEKLIES AND DAILIES

As with all technical indicators, signals on weekly charts are always more important than those on daily charts. The best way to combine them is to use weekly signals to determine market direction and the daily signals to fine-tune entry and exit points. A daily signal is followed only when it agrees with the weekly signal. Used in that fashion, the weekly signals become trend filters for daily signals. That prevents using daily signals to trade against the prevailing trend. Two crossover systems in which this principle is especially true are MACD and Stochastics. (See Figure 10.20b.)

Figure 10.20b The MACD histogram works well on weekly charts. At the middle peak, the histogram turned down 10 weeks before the sell signal (down arrow). At the two upturns, the histogram turned up 2 and 4 weeks before the buy signals (up arrows).

THE PRINCIPLE OF CONTRARY OPINION IN FUTURES

Oscillator analysis is the study of market extremes. One of the most widely followed theories in measuring those market extremes is the principle of Contrary Opinion. At the beginning of the book, two principal philosophies of market analysis were identified—fundamental and technical analysis. Contrary Opinion, although it is generally listed under the category of technical analysis, is more aptly described as a form of psychological analysis. Contrary Opinion adds the important third dimension to market analysis—the psychological—by determining the degree of bullishness or bearishness among participants in the various financial markets.

The principle of Contrary Opinion holds that when the vast majority of people agree on anything, they are generally wrong. A true contrarian, therefore, will first try to determine what the majority are doing and then will act in the opposite direction.

Humphrey B. Neill, considered the dean of contrary thinking, described his theories in a 1954 book entitled, The Art of Contrary Thinking. Ten years later, in 1964, James H. Sibbet began to apply Neill’s principles to commodity futures trading by creating the Market Vane advisory service, which includes the Bullish Consensus numbers (Market Vane, P.O. Box 90490, Pasadena, CA 91109). Each week a poll of market letters is taken to determine the degree of bullishness or bearishness among commodity professionals. The purpose of the poll is to quantify market sentiment into a set of numbers that can be analyzed and used in the market forecasting process. The rationale behind this approach is that most futures traders are influenced to a great extent by market advisory services. By monitoring the views of the professional market letters, therefore, a reasonably accurate gauge of the attitudes of the trading public can be obtained.

Another service that provides an indication of market sentiment is the “Consensus Index of Bullish Market Opinion,” published by Consensus National Commodity Futures Weekly (Consensus, Inc., 1735 McGee Street, Kansas City, MO 64108). These numbers are published each Friday and use 75% as an overbought and 25% as an oversold measurement.

Interpreting Bullish Consensus Numbers

Most traders seem to employ a fairly simple method of analyzing these weekly numbers. If the numbers are above 75%, the market is considered to be overbought and means that a top may be near. A reading below 25% is interpreted to warn of an oversold condition and the increased likelihood that a market bottom is near.

Contrary Opinion Measures Remaining Buying or Selling Power

Consider the case of an individual speculator. Assume that speculator reads his or her favorite newsletter and becomes convinced that a market is about to move substantially higher. The more bullish the forecast, the more aggressively that trader will approach the market. Once that individual speculator’s funds are fully committed to that particular market, however, he or she is overbought—meaning there are no more funds to commit to the market.

Expanding this situation to include all market participants, if 80-90% of market traders are bullish on a market, it is assumed that they have already taken their market positions. Who is left to buy and push the market higher? This then is one of the keys to understanding Contrary Opinion. If the overwhelming sentiment of market traders is on one side of the market, there simply isn’t enough buying or selling pressure left to continue the present trend.

Contrary Opinion Measures Strong Versus Weak Hands

A second feature of this philosophy is its ability to compare strong versus weak hands. Futures trading is a zero sum game. For every long there is also a short. If 80% of the traders are on the long side of a market, then the remaining 20% (who are holding short positions) must be well financed enough to absorb the longs held by the other 80%. The shorts, therefore, must be holding much larger positions than the longs (in this case, 4 to 1).

This means further that the shorts must be well capitalized and are considered to be strong hands. The 80%, who are holding much smaller positions per trader, are considered to be weaker hands who will be forced to liquidate those longs on any sudden turn in prices.

Some Additional Features of the Bullish Consensus Numbers

Let’s consider a few additional points that should be kept in mind when using these numbers. The norm or equilibrium point is at 55%. This allows for a built-in bullish bias on the part of the general public. The upper extreme is considered to be 90% and the lower extreme, 20%. Here again, the numbers are shifted upward slightly to allow for the bullish bias.

A contrarian position can usually be considered when the bullish consensus numbers are above 90% or under 20%. Readings over 75% or under 25% are also considered warning zones and suggest that a turn may be near. However, it is generally advisable to await a change in the trend of the numbers before taking action against the trend. A change in the direction of the Bullish Consensus numbers, especially if it occurs from one of the danger zones, should be watched closely.

The Importance of Open Interest (Futures)

Open interest also plays a role in the use of Bullish Consensus numbers. In general, the higher the open interest figures are, the better the chance that the contrarian positions will prove profitable. A contrarian position should not be taken, however, while open interest is still increasing. A continued rise in open interest numbers increases the odds that the present trend will continue. Wait for the open interest numbers to begin to flatten out or to decline before taking action.

Study the Commitments of Traders Report to ensure that hedgers hold less than 50% of the open interest. Contrary Opinion works better when most of the open interest is held by speculators, who are considered to be weaker hands. It is not advisable to trade against large hedging interests.

Watch the Market’s Reaction to Fundamental News

Watch the market’s reaction to fundamental news very closely. The failure of

prices to react to bullish news in an overbought area is a clear warning that a turn may be near. The first adverse news is usually enough to quickly push prices in the other direction. Correspondingly, the failure of prices in an oversold area (under 25%) to react to bearish news can be taken as a warning that all the bad news has been fully discounted in the current low price. Any bullish news will push prices higher.

Combine Contrarian Opinion with Other Technical Tools

As a general rule, trade in the same direction as the trend of the consensus numbers until an extreme is reached, at which time the numbers should be monitored for a sign of a change in trend. It goes without saying that standard technical analytical tools can and should also be employed to help identify market turns at these critical times. The breaking of support or resistance levels, trendlines, or moving averages can be utilized to help confirm that the trend is in fact turning. Divergences on oscillator charts are especially useful when the Bullish Consensus numbers are overbought or oversold.

INVESTOR SENTIMENT READINGS

Each weekend Barron’s includes in its Market Laboratory section a set of numbers under the heading “Investor Sentiment Readings.” In that space, four different investor polls are included to gauge the degree of bullishness and bearishness in the stock market. The figures are given for the latest week and the period two and three weeks back for comparison purposes. Here’s a random sample of what the latest week’s figures might look like. Remember that these numbers are contrary indicators. Too much bullishness is bad. Too much bearishness is good.

investor’s intelligence
Bulls	48%
Bears	27
Correction	24
Consensus Index
Bullish Opinion	77%
AAII Index (American Association of Individual Investors 625 N. Michigan Ave. Chicago, IL 60611)
Bullish	53%
Bearish	13
Neutral	34
Market Vane
Bullish Consensus	66%

INVESTORS INTELLIGENCE NUMBERS

Investors Intelligence (30 Church Street, New Rochelle, NY 10801) takes a weekly poll of investment advisors and produces three numbers—the percent of investment advisors that are bullish, those that are bearish, and those that are expecting a market correction. Bullish readings over 55% warn of too much optimism and are potentially negative for the market. Bullish readings below 35% reflect too much pessimism and are considered positive for the market. The correction figure represents advisers who are bullish but expecting short term weakness.

Investors Intelligence also publishes figures each week that measure the number of stocks that are above their 10 and 30 week moving averages. Those numbers can also be used in a contrary fashion. Readings above 70% suggest an overbought stock market. Readings below 30% suggest an oversold market. The 10 week readings are useful for measuring short to intermediate market turns. The 30 week numbers are more useful for measuring major market turns. The actual signal of a potential change in trend takes place when the numbers rise back above 30 or fall back below 70.

*The second smoothing produces 3 lines. Fast stochastics uses the first 2 lines. Slow stochastics uses the last 2 lines.

INTRODUCTION

The first charting technique used by stock market traders before the turn of the century was point and figure charting. The actual name “point and figure” has been attributed to Victor deVilliers in his 1933 classic, The Point and Figure Method of Anticipating Stock Price Movements. The technique has had various names over the years. In the 1880s and 1890s, it was known as the “book method.” This was the name Charles Dow gave it in a July 20, 1901 editorial of The Wall Street Journal.

Dow indicated that the book method had been used for about 15 years, giving it a starting date of 1886. The name “figure charts” was used from the 1920s until 1933 when “point and figure” became the accepted name for this technique of tracking market movement. R.D. Wyckoff also published several works dealing with the point and figure method in the early 1930s.

The Wall Street Journal started publishing daily high, low, and closing stock prices in 1896, which is the first reference to the more commonly known bar chart. Therefore, it appears that the point and figure method predates bar charting by at least 10 years.

We’re going to approach point and figure charting in two steps. We’ll look at the original method that relies on intraday price moves. Then we’ll show you a simpler version of point and figure charting that can be constructed by using only the high and low prices for any market.

THE POINT AND FIGURE VERSUS THE BAR