Alan Hull is a second generation share trader, fund manager, businessman, teacher, writer, mathematician, I.T. expert and popular speaker on the seminar circuit. He is the best-selling author of 'Blue Chip Investing' and 'Active Investing', both by Wrightbooks.
Alan speaks extensively throughout Australia for organisations such as the Australian Stock Exchange, Australian Investors Association, Australian Technical Analyst's Association and at the Investment Expo and Traders Expo. His books, articles and newsletters are published and widely read throughout Australia and overseas. Alan's newsletters are based on his trading strategies 'Active Fund Management' (which is explained in his book 'Blue Chip Investing') and 'Active Investing' (which is explained in his book 'Active Investing').
MACD IN BREAKOUT TRADING
The MACD indicator is one of the simplest momentum indicators to understand. It was developed by Gerald Appel in the late 1970's and it is now a popular indicator available in most charting software packages. The name, MACD, is an acronym for 'Moving Average Convergence Divergence'. Even though the name sounds complicated it is easy to understand and use. For this reason I like the MACD indicator, and I also find it very effective for trading purposes. It is a major component in one of my trading strategies called Breakout trading.
Breakout trading is not a trend trading strategy but a momentum trading strategy. It identifies pattern based breakouts and trades any rally that follows using momentum. The chart below shows a breakout from a period of consolidation followed by a rally. The MACD indicator is used to track the progress of the rally and provide the exit signal.
In this article I will be focusing on the use of the MACD indicator in terms of my breakout trading strategy but you can find more information about other aspects of the strategy at, www.alanhull.com where you can enrol in my free breakout trading course.
The main advantage of breakout trading, as opposed to trend trading, is that it finds plenty of opportunities in many different market conditions. There is no need to wait for the market to trend before trades can be identified. Furthermore the way the MACD indicator is used to signal an exit means trades are promptly closed at the first sign of trouble; another advantage when market conditions become less than favourable.
The MACD indicator can be used in various ways for trading purposes. I use it in two different ways in breakout trading. But first let's look at how the indicator is constructed. I did mention that it is one of the simplest momentum indicators to understand.
As its name suggests it measures the convergence and divergence of moving averages; in particular, two moving averages. Gerald Appel, the indicator's developer, suggested using 12 and 26 period exponential moving averages; and to keep things simple I tend to stick with these default settings. The MACD line is calculated as the difference between these two moving averages (MA's).
When the price rises at an increasing rate the two moving averages diverge. This means the difference between the MA's is increasing and consequently the MACD line rises. When the price starts to slow down or reverse, the moving averages converge. This means the difference between the MA's is reducing and the MACD line falls.
The chart above shows how the MACD line follows the convergence and divergence of the moving averages and hence tracks the momentum in the price movement.
The thin black line in the chart above is called the signal line. This is a standard element of the MACD indicator and is a moving average of the MACD line, generally with a default period of 9. We'll discuss this more later in this article.
For breakout trades, I simply use the direction of the MACD line (red line). In a breakout to the upside we want the price to rise, see next chart. This means the momentum is increasing and the MACD line is rising. We want to exit the trade as soon as the price stops rising. This is signaled when the momentum weakens, the two MA's converge and the MACD line begins to fall.
The chart below shows the MACD line rising during the trade and falling away at the end of the rally. You can see how the direction of the MACD line provides a timely exit, capturing the majority of the rally. In essence the breakout pattern provides a high probability for a rally to occur, and the MACD line captures any rally that does occur.
Breakout trading is a short term system. It works well when implemented on a weekly basis. It is quite versatile across many different market conditions. In highly volatile conditions where there are a series of reversals, sometimes rallies can fail to extend but otherwise the short term nature of the system identifies good opportunities fairly regularly.
For position sizing and risk management I do include a price based stop loss to work alongside the MACD (momentum based) exit trigger. This is like a safety net. The red dots on the chart below show the price based stop loss. However, on many occasions, such as in the chart below, it is the MACD exit signal that is triggered before the price based stop loss, giving a prompt exit from the rally.
Another feature often displayed with the standard MACD indicator is a zero line. This helps identify the relative position of the MACD and signal line with respect to the broader price movement. In our case it shows the relative position of the breakout pattern in the broader picture of the share in question. The following charts show some examples.
If a breakout occurs as part of a reversal pattern then the MACD line at the moment of the breakout is likely to be below the zero line, such as in Figure 5 below. If the breakout is part of an existing trend the MACD line at the breakout is likely to be above the zero line, such as in Figure 6 below.
Both situations are acceptable when breakout trading. This demonstrates another versatile use of breakout trading of identifying trades at different market stages. Breakouts also occur to the downside and can be traded with Short selling. In these cases the MACD line needs to be falling during the trade and the exit signal will occur when the MACD line turns up - basically the system is flipped upside down for breakouts to the downside.
I use the MACD indicator as part of my breakout trading strategy in a couple of different ways. The first way, as previously discussed is for tracking momentum following a breakout, see chart below. The momentum (MACD line) rises during the trade and an exit is signaled when the momentum weakens and the MACD line turns down - a very simple but effective method for capturing a breakout rally.
This method of trading is very effective and has the advantage of capturing short term trades in all sorts of market conditions. However, when the general market is in an established trend many breakout rallies end, but the price often continues to trend. When this happens I call the trend continuations; 2nd waves.
Price often moves in waves. A breakout rally is really the first wave after the period of consolidation. Therefore the next wave after the breakout trade is the 2nd impulsive wave. The next chart shows an example of a breakout trade followed by a 2nd wave trade.
A 2nd wave can be traded but requires a modified approach. The key point to note is that a 2nd wave trade, whilst it follows a breakout trade, is really more of a trend trade.
Therefore, it needs to be treated in a slightly different manner to the breakout trade. The MACD indicator can still be used but in a different way to the breakout trade. Instead of waiting for the MACD line to fall to trigger the exit, we wait for the MACD line to cross the signal line to give the 2nd wave exit.
The signal line is the thin black line in the chart below. It is an exponential moving average of the MACD line, with a default period of 9. It lags the MACD line causing crossovers to occur as the price fluctuates.
This method of taking signals at the crossover points is the most commonly cited method for using the MACD indicator. In my strategy I am only using the MACD crossover as the exit signal in the 2nd wave part of the system. The following chart shows a breakout and 2nd wave.
Let's work through the two trades in the above chart in terms of the MACD indicator. Firstly, the breakout entry occurs following a period of consolidation based on pattern based criteria.
At the breakout, the MACD line is rising. It continues to rise throughout the breakout rally. The exit from the breakout rally occurs when the MACD line turns down - as the momentum of the rally weakens. This is the end of the breakout trade.
The price pauses after the breakout exit but does not reverse. At the same time the MACD line falls but does not cross the signal line. As time moves on the MACD line turns up again and hence indicates the beginning of a 2nd wave. The 2nd wave trade can be entered when the MACD line turned up on the proviso that the MACD line has not crossed the signal line.
The 2nd wave trade is tracked as a trend trade allowing the MACD line to rise and fall providing it does not cross the signal line. A crossover of the MACD line and the signal line indicates an exit to the 2nd wave trade.
Second wave trades do not generally present themselves unless the broad market is trending. In more sideways conditions most of the trades identified by this system are breakout trades. However, when the market is trending this system provides the means to capture breakout trades plus 2nd wave trades without the need for extra tools and indicators.
Overall, the MACD indicator is a useful and practical tool when trading. Its versatility within breakout trading means I can have two styles of trading in the same system, using the same indicators.
Published in parts: 10 October 2012 to 1 November 2012 - Copyright © Alan Hull
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