The MACD indicator is a useful addition to any stock trading strategy. It is a good measure of momentum, trend direction and can also be a good guide to the relative strength of the market, indicating whether the market is overbought or oversold.

However, like all technical indicators there are a number of advantages and disadvantages that any trader should know before incorporating it into their strategy.

Disadvantages

The main disadvantage of the MACD indicator is that it is subjective to the user. Like many technical indicators, the MACD has settings that can be changed to give almost limitless numbers of variations which means results will always differ from person to person.

A trader must decide for example what moving averages to choose. The suggested settings are the 12 day moving average, 26 day and 9, however, these can easily be changed. Secondly, a trader must know what time frame the MACD works best on and there are no easy answers, since the MACD will tend to work differently across different markets. Generally, however, the MACD works best when it is confirmed across several different time frames – especially further out time frames such as the weekly chart.

Lagging indicator

Unless using the divergence strategy (more on this later) which seeks to pick tops and bottoms before they occur, the MACD has an inherent disadvantage that occurs with all technical indicators that concern price history such as moving averages. Since moving averages are lagging indicators, in that they measure the change in a stock price over a period of time (in the past), they tend to be late at giving signals. Often, when a fast moving average crosses over a slower one, the market will have already turned upwards some days ago. When the MACD crossover finally gives a buy signal, it will have already missed some of the gains, and in the worst case scenario it will get whipsawed when the market turns back the other way. The best way to get around this problem is to use longer term charts such as hourly or daily charts (since these tend to have fewer whipsaws). It is also a good idea to use other indicators or time frames to confirm the signals.

The chart below of the Spyders (SPY) clearly shows the lagging nature of the MACD.

While the crossover strategy has the limitation of being a lagging indicator, the divergence strategy has the opposite problem. Namely, it can signal a reversal too early causing the trader to have a number of small losing trades before hitting the big one. The problem arises since a converging or diverging trend does not always lead to a reversal. Indeed, often a market will converge for just a bar or two catching its breath before it picks up momentum again and continues its trend.

MACD divergence and multiple time frames

Actually this is a useful feature of the MACD. Bear in mind the lagging nature of the indicator, looking for divergences between price action and the indicator over multiple time frames makes more sense. In the chart of the SPY above the multiple daily MACD divergences are evident, but prices kept moving higher nevertheless. Prices didn’t break down until 07/25/14 and then corrected for about 5%.

Looking at a weekly chart over the same period, the MACD divergence is evident but only one occurrence is apparent and that occurs at the week ending 07/25/14.

MACD divergence and double tops and bottoms

The multiple timeframe divergence does alleviate some of the whipsaws when using MACD. If we then look at only double tops or bottoms with MACD divergence and multiple time frames, we are effectively using multiple confirmation techniques.

Take the recent top in the market 09/18/14. Prices had reached a new high 09/4/14 then retraced for 7 days before reaching the same peak on 09/18/14. A double top. The chart below shows the MACD indicator clearly diverging as the double top occurs. Prices have corrected over 5% from the peak.

No indicator is foolproof, but combining multiple techniques and time frames does provide greater insight.

Wow, does Murphy hate my guts, or what?

So I write an article all about how the stock market gets all bullish during the middle 18 months of the decade (September 30th – Mark Your Calendar) – i.e., starting at the close on September 30th of the mid-term election year – and what does Murphy go and do?  He (She? Hmmm, that might explain a few things) invokes his (her?) dreaded Law and the market gets hammered right out of the box in early October.

Fortunately for me I have made enough mistakes in the market over the years that I don’t even bother to feel stupid anymore when things go exactly the opposite of what I might have anticipated.  This leads me to invoke a maxim I adopted (after a long, painful process) a long time ago:

Jay’s Trading Maxim #412: Murphy hates you.  Plan accordingly.

To put it into other terms, it essential for any trader or investor to give some thought as to  what might go wrong before taking any particular action and to come up with an answer to the following question:

“What is my worst case scenario and what specific action will I take to mitigate the damage should this scenario unfold?”

Sounds like such an obvious question to ask and answer doesn’t it?  But here is another question that will likely make a lot of readers squirm:

“Do you have an answer to the question above?  Every time you make a trade?”
OK granted that’s two questions, but you get my drift.

Where to From Here?
So here is the part of the article where most “highly trained professional market analysts” tell you why the market is almost certain to rise (or fall) from here. Unfortunately, the bad news for me is that I am not very good at predicting the future (plus let’s face it, I can’t risk pissing Murphy off again).  So while it “feels” like the market could melt down at any moment, I have little choice but to simply follow my plan and give the bullish case the benefit of the doubt.  So two things to note:

#1. October through December in Mid-Term Election Years
In Figure 1 you can see the growth of $1,000 invested in the Dow Jones Industrials Average only during the months of October, November and December during mid-term election years, starting in 1934 (i.e., 1934, 1938, 1942, etc.)

 Figure 1 – Growth of $1,000 invested in DJIA Oct-Nov-Dec of Mid-Term Election Year (1934-present)

Figure 2 shows the year-by-year results

As you can see, this period has showed a gain 90% of the time.  Granted a few were pretty miniscule, still the median gain was in excess of 8% and the worst previous performance was -7%.

#2. Short-Term Oversold
Well I could hardly refer to myself as a highly trained professional market analyst if I didn’t have my own proprietary  overbought/oversold indicator, so, voila, surprise, surprise, my own proprietary overbought/oversold indicator (cleverly named JKOBOS) appears in Figure 3.

 Figure 3 – Jay’s Overbought/Oversold Indicator is flashing an oversold (i.e., theoretically bullish) signal at the moment (Chart courtesy of AIQ TradingExpert)

A close look at the chart in Figure 3 reveals that JKOBOS readings below 25 tend to highlight decent buying opportunities.  With the indicator presently standing at 21.8, this qualifies as at least a “bullish alert”.

Summary
So is the combination of a bullish seasonal trend (i.e., October through December of Mid-Term election years) and an oversold market (based on a reading from my own overbought/oversold indicator) telling us that another rally is in the near future? 

The honest answer is “not necessarily”.  The optimistic answer however, is that despite the fear and loathing that seems to permeate the market these day (or maybe partly because of it), there is a chance that the market could surprise to the upside.  As a dutiful trend follower I personally have little choice but to continue to give the bullish case the benefit of the doubt

Just don’t anyone tell Murphy I said that………sssshhhh!

Jay Kaeppel  
Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client
http://jayonthemarkets.com/

With the beginning of October a couple of days away, here’s our seasonal analysis for the month. We’ve also embedded a table with the scan results that will make it easier to see the results.

A refresher on this scan and some notes about changes.

We have noted on several occasions that we are using 7 years of historical data in the Comparison charts and that is true, however the scan actually looks at 8 years, so in future charts we’ll add the eighth year.

Our study looks at 8 years of historical data and looks at the returns for all optionable stocks 2006 to 2013.

We filter to find two sets of criteria

– Stocks with gains in all 8 years during October
– Stocks with losses in all 8 years in October

We do make an assumption that the month is 21 trading days and work our way back from the last day of the month. If the last day of the month falls on a weekend, then we use the first trading day prior to that date.

We make no assumptions for drawdown, nor do we look at the fundamentals behind such a pattern. We do compare the stock to the market during the same period and look at the average SPY gain/loss vs. the average stock gain/loss. This helps filter out market influence. We are now including group information to identify particular segments that might display a seasonal bias.

Finally we look at the median gain/loss and look for statistical anomalies, like meteoric gains/loss in one year.

WLT – Walter Energy seasonality through October 2013 – 7 year average in black

SWN – Swan Energy seasonality through October 2013

DV – Devry seasonality through October 2013

At the beginning of September I ran the seasonality scan as usual and was disappointed to find very little that looked attractive. 2 stocks met the scan to the upside, but with very poor consistency. September can be a tough month. It was only later in the month I realized I’d made an error and had scanned only the S&P500 stocks! Live and learn.

So, rather than do the September analysis as an exercise now we’re at the 23rd, instead here’s an update on how the scan on August seasonal players panned out. At the end of this week we’ll do the October run.

First a refresher on this scan

First off some background.

Our study looks at 7 years of historical data and looks at the returns for all optionable stocks for the month of August from 2006 to 2013.

We filter to find two sets of criteria

 – Stocks with gains in all 7 years during August
 – Stocks with losses in all 7 years in August

We do make an assumption that the month is 21 trading days and work our way back from the last day of the month. If the last day of the month falls on a weekend, then we use the first trading day prior to that date.

We make no assumptions for drawdown, nor do we look at the fundamentals behind such a pattern. We do compare the stock to the market during the same period and look at the average SPY gain/loss vs. the average stock gain/loss. This helps filter out market influence. We are now including group information to identify particular segments that might display a seasonal bias.

Finally we look at the median gain/loss and look for statistical anomalies, like meteoric gains/loss in one year.

there were 2 stocks that had the most consistent patterns. They were UPL and DNR

DNR is Denbury Resources and it opened at $16.89 before dropping to around $16.13 into the middle of August. By the last trading day in August DNR closed at $17.22 for a modest gain of 1.95%.

UPL is Ultra Pete Corp and it opened at $22.97 and was relatively unchanged for the first half of August before rallying to close the month at $26.53 for a gain of 15.5%.

Before we leap off the cliff, I must point out that the market return in August over the 7 years is a paltry average of -0.06, as measured by SPY. However this August SPY gained 4.2%.

Here’s the charts for the 2 stocks.

See you again later this week with October’s seasonals.

In my last article (http://tinyurl.com/mzhstm2) I wrote about a simple entry method I have dubbed “The RSI 3 Strikes and You’re Out Play” or TSYO, for short.

The RSI 3 Strikes and You’re Out Method is a good candidate for option traders as it offers the potential to “make a few bucks” when the market experiences a pullback.  So this week I want to offer a few examples.
In the interest of full disclosure I had planned to do it last week, but once my family and I arrived in Aruba I quickly settled into the “Sleep Late, Run on the Beach, Lay on the Beach, Swim in the Ocean and the Pool, Shower, Go to Dinner, Repeat” routine.  And in the midst of that “busy” schedule I found little time to write.

TSYO Examples
I have a list of stocks and ETFs that I follow for option trading purposes.  Not necessarily the “definitive” list but a good mix of tickers that trade lots of option volume.  The list in Figure 1 displays some recent TSYO signals for some of the stocks on my list. 

*The first column shows the stock ticker. 
*The second column shows the date of the “Alert” signal (i.e., the 2nd non confirmation by RSI). 
*The third column shows the date that the stock or ETF takes out the low of the previous three days. 

Figure 1 – TSYO Alerts and Triggers

For the purposes of this article we will assume that a put option is bought at the close of the “3-Day Low” day.  For deciding which put option to buy we will use the “Percent to Double” routine found at www.Optionsanlysis.com.

One note, while I will highlight the profit potential for each trade reviewed, I will not detail any specific “exit criteria”.  My goal is to highlight the entry signal and not necessarily create a mechanical “system”.  I also think that each trader should do some thinking and consider their own criteria for when to take a profit or cut a loss.

Ticker AMGN
As you can see in Figures 1 and 2, AMGN triggered an “Alert” on 7/3 and made a new 3-day low on 7/8.

What followed was little more than a modest short-term pullback.  Still, as you can see in Figure 3, if a trader bought the October 120 put option on 7/8, by 7/17 he or she would have had an open profit of +40.5%.

Ticker AMZN
In this example waiting for a 3-day low before entering actually worked against a trader because on 7/25 AMZN gapped significantly lower as you can see in Figure 4.

 

Nevertheless, if a trader had bought the September 320 put option at the close on 7/25, by 8/1 he or she would have had an open profit of +69.4%.

Ticker F
The example that follows for Ford (ticker F) highlights two things:
1. The ability to essentially “bet” on a short-term pullback while risking a relatively small amount of capital
2. The above average profit potential associated with trading options.
Ticker F triggered an “Alert” on 7/24 and made a new 3-day low on 7/25.

If a trader had bought the September 17 put option at the close on 7/25, by 8/1 he or she would have had an open profit of +103.6%.

 

Summary
So once again, the point of all of this is not to attempt to promote the “be all, end all” of trading.  Because the TSYO method is most certainly not that.  But it can do a pretty decent job of identifying opportunities (especially after the overall market has experienced an extended run up and may be running out of team near term).  For traders who are willing to consider alternative (though simple) strategies such as buying put options, a method such as this can offer the potential to make money even as the overall market pulls back.
No one should go out and start making trades using the method I have detailed here without doing some further study/analysis/etc.  But the real point of all of this is that it is possible to use relatively simple ideas and relatively little capital to achieve trading success.

Jay Kaeppel  
Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client