Mad Science with Dr. Elder & Mr Appel
*This was originally posted at blfgria.com on 8/22/2011*
It is no secret (anywhere) by now that the markets have fallen off a cliff and given back all the gains for the last year. They have suffered a great deal of damage in a very short period of time and when we see extremes like this it often leads to a snapback rally recently coined by Josh Brown (@reformedbroker) as a face-ripping rally. In this post I don’t want to debate if we are in a bear market or not or when we should have a bounce. All I want to do here is give you another tool to use when looking for buys after a strong drop. Of course, this can be turned around to look for shorts as well, but shorting has a lot of other factors that need to be considered so here we will stick to longs. As I was looking through my charts this weekend I was reminded of two charting techniques I use that both involve MACD.
The MACD is a great trend following indicator that is the difference between a fast and slow moving average with a signal line. This indicator also can be shown in a MACD histogram which can be used to identify early reversal signals if applied right. According to Dr. Elder in Come into My Trading Room a MACD Histogram divergence signal is the strongest signal you can get. They are rare and only come along a couple of times a year, but when you do they can be a turning point in prices that can last weeks or months. As any good professional does, he also talks about the need to use stops because no one can predict the markets. These signals can be very powerful and used with most any trading timeframe. I have seen them work well on a swing and position basis. The rules he uses for identifying these divergences are you have compare the peaks and bottoms of price and the MACD Histogram. As with any bullish divergence the price makes new lows while the histogram makes a higher low, but the key is the intervening peak in the histogram must move above the zero line. This is said to break the back of the bears allowing the higher histogram low to be more trustworthy. Let’s jump in and take a look at one of the signals that triggered earlier this year in BIDU. In the BIDU chart below as you can see I have the X point and the reference point labeled as well as the intervening histogram peak (A). The signal that is marked is on the normal 12,26,9 histogram as Dr Elder used.
Dr Elder uses the first uptick from the reference point as the buy signal which does work well, however also lends to more whipsaws. I prefer using the cross above zero line (denoted by the arrow) which still gives an early entry with less chance of getting stopped out of a good signal as many of these retrace a portion after the signal occurs. The trade off is your stop is wider with my variation. This signal in BIDU would have gotten you in around 127 before a run all the way to 165 within two months for a roughly 30% gain. Notice the signal gets you in early before the trendline break shown. When reviewing for these signals you will notice this happens a lot.
Now in his work Dr Elder talks about adjusting the time periods for MACD to look for what works best with the markets you watch, but conceded the default 12,26,9 worked well enough for most traders. I personally follow many different markets, so I don’t have time to look to each one of them to build a custom interval and that is where Mr Appel comes in. In his recent book Techical Analysis: Power Tools for Active Investors, Mr Appel talked about using other interval combinations that he recommended to speed up or slow down the signals. In his book he used different combinations of buy and sell signals using the three different MACDs depending on the market environment and trading timeframe (save that for another post). The shorter timeframe he uses is a 6,19,9 and the longer a 19,39,9. For those who want to play the next bounce I think they can use the shorter 6,19,9 interval and apply Dr. Elders MACD Histogram divergence play and increase the probability of bounce plays working if/when the markets or a security finds their respective bottoms at least in the short term. In the GOLD chart below you can see the signal in the shorter average is marked and preceded the big run the stock is currently in.
This signal was a gem as it go you in around 80 and as of Friday the stock was just under 110. If you look to the beginning of the chart you can see an earlier signal that was not as strong and only gained about 5% before falling back. We can also go back to the BIDU chart above and see that in the shorter interval MACD Histogram not only did we get the buy signal, but also a very prescient sell signal using the same idea at the top. Even though both these examples show the divergence in more than one of the MACD intervals, these signals show up in some cases in the shorter intervals that they don’t in either of the longer periods which is why I would use them in these markets if you have good money management skills. The BIDU sell signal only showed up in the shorter interval histogram. In fast markets like these, you have to strike quick and manage the trade if you are going to attempt to catch a bounce and the shorter interval provides for that. If the current retest by the broader markets is successful I would expect many of these setups to be present. Once they show up only time will tell how they work out.
One last little tidbit from Dr Elder that we should keep in mind is another signal when trading the MACD Histogram signal (which he considers the strongest signal) called the “Hound of Baskervilles” signal. This is when the strongest signal fails. This goes back to the adage a failed move leads to a fast move, and Dr Elder sees a failed MACD Histogram signal worth reversing your position in many cases. That is a hard thing to do for most traders, but looking back we all know how many times it would have made sense. I believe this advice should be considered in most situations where a very strong signal fails, but Dr. Elder only speaks of it in terms of the MACD Histogram signal.
It is tools like these that keep me in the camp with Greg Harmon (@harmongreg) about indicators providing value to those who know how to read them. Only price pays as Brian Shannon (@alphatrends)always says, but having an edge such as this when going into trading can help tremendously. I have no idea exactly when these markets will bounce, but at some point they will and those who wish to catch some upside can add this tool to your trading toolbox. For those who are looking for longer positions this signal can be incorporated with the broader technical picture as a building block. As with many technical tools, I believe these histogram divergences can be valuable to monitor no matter what timeframe you trade.
References:
Technical Analysis: Power Tools for Active Traders by Gerald Appel
Come Into My Trading Room by Dr. Alexander Elder
Good Luck, it is there for the making!
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