Exit Strategies - Using MACD to signal a turn in trend.
The MAC indicator that is used every day in this column can also be used as
a leading indicator to help a trader pick turning points.
Let's review what MACD is and look at an example.
The MACD "Moving Average Convergence/Divergence" is a trend following
momentum indicator that shows the relationship between three moving
averages of prices.
This method can be used for any time frame. It could be 5 minute bars, 15
minutes bars, 60 minute, or daily bars. Many traders will also trade in
multiple time frames using a longer time frame for trend, and the shorter
period for entry and exit.
The MACD is the difference between a 26-period and 12-period exponential
moving average. A 9 period exponential moving average, called the "signal"
(or "trigger") line is plotted on top of the MACD to show buy/sell
opportunities. On the charts below, the MACD line is the green colored
line, and the trailing, slower moving line is the signal line. Some
technical analysis programs will show the MACD as a histogram bar.
There are three popular ways to use the MACD: crossovers,
overbought/oversold conditions, and divergences.
The most common use is as a crossover method. Using this interpretation,
the trading rule is to sell when the MACD falls below its signal line.
Similarly, a buy signal occurs when the MACD rises above its signal line.
It is also popular to buy/sell when the MACD goes above/below zero.
Some traders will use MACD as an overbought and oversold indicator. When
using the indicator in this manner, when the shorter moving average pulls
away dramatically from the longer moving average (i.e., the MACD rises), it
is likely that the security price is overextending and will soon return to
more realistic levels. MACD overbought and oversold conditions vary from
security to security.
The other way some traders use MACD is to spot divergences from an
anticipated movement. Since there are no indicators or patterns that work
all the time, reactions against the anticipated move can signal a major
move. A bearish divergence occurs when the MACD is making new lows while
prices fail to reach new lows. A bullish divergence occurs when the MACD is
making new highs while prices fail to reach new highs. Both of these
divergences are most significant when they occur at relatively
overbought/oversold levels.
The moving average crossover method calculates two moving averages, each
based on a different number of periods of trading data. When the
shorter-term (fewer periods) average crosses above the longer-term average
from below, this is a buy signal. When the shorter-term average crosses
below the longer-term average from above, this is a sell signal.
Let's look at America Online, (NYSE: AOL)
On August 10, the MACD gave a Buy signal on AOL and we saw a steady rise in
AOL.
On Friday and today, it looks like AOL has stalled in the 96 - 98 range.
The MACD indicator is showing a slowing in momentum from the rise from 82
to 98.
AOL looks ready for a retracement and/or a continuation of a longer-term
downtrend.
Notice how the momentum indicator and OBV is also turning down.
I would exit longs in AOL.
An aggressive trader may consider a Short here in AOL.
I would place my stop for a short at 98 �.
If my stop was hit, I would actually reverse positions and go long again at
98 �.
