Trading Diary

Secret #5: Invest Simply.

The best way to own common stocks is through an index fund. – Warren Buffett

Secret #6: Have a mentor in life.

I was lucky to have the right heroes. Tell me who your heroes are and I’ll tell you how you’ll turn out to be. The qualities of the one you admire are the traits that you, with a little practice, can make your own, and that, if practiced, will become habit-forming. – Warren Buffett

Secret #7: Making money isn’t the backbone of our guiding purpose; making money is the by-product of our guiding purpose.

If you’re doing something you love, you’re more likely to put your all into it, and that generally equates to making money. – Warren Buffett

The MACD-Histogram is an indicator of an indicator or a derivative of a derivative. The MACD is the first derivative of the price action of a security, and the MACD-Histogram is the second derivative of the price action of a security. As the second derivative, the MACD-Histogram is further removed from the actual price action of the underlying security. The further removed an indicator is from the underlying price action, the greater the chances of false signals. Keep in mind that this is an indicator of an indicator. The MACD-Histogram should not be compared directly with the price action of the underlying security.

Because MACD-Histogram was designed to anticipate MACD signals, there is a temptation to jump the gun. The MACD-Histogram should be used in conjunction with other aspects of technical analysis. This will help to alleviate the temptation for early entry. Another means to guard against early entry is to combine weekly signals with daily signals. Of course, there will be more daily signals than weekly signals. However, by using only the daily signals that agree with the weekly signals, there will be fewer daily signals to act on. By acting only on those daily signals that are in agreement with the weekly signals, you are also assured of trading with the longer trend and not against it.

Be careful of small and shallow divergences. While these may sometimes lead to good signals, they are also more apt to create false signals. One method to avoid small divergences is to look for larger divergences with two or more readily identifiable peaks or troughs. Compare the peaks and troughs from past action to determine significance. Only peaks and troughs that appear to be significant should warrant attention.

The main benefit of the MACD-Histogram is its ability to anticipate MACD signals. Divergences usually appear in the MACD-Histogram before MACD moving average crossovers do. Armed with this knowledge, traders and investors can better prepare for potential trend changes.

The weekly MACD-Histogram can be used to generate a long-term signal in order to establish the tradable trend. Then only short-term signals that agree with the major trend would be considered. If the long-term trend were bullish, only negative divergences with bearish centerline crossovers would be considered valid for the MACD-Histogram. If the long-term trend were bearish, only positive divergences with bullish centerline crossovers would be considered valid.

Moving averages, be they simple, exponential or weighted, are lagging indicators. Even though MACD represents the difference between two moving averages, there can still be some lag in the indicator itself. This is more likely to be the case with weekly charts than daily charts. One solution to this problem is the use of the MACD-Histogram.

MACD is not particularly good for identifying overbought and oversold levels. Even though it is possible to identify levels that historically represent overbought and oversold levels, MACD does not have any upper or lower limits to bind its movement. MACD can continue to overextend beyond historical extremes.

MACD calculates the absolute difference between two moving averages and not the percentage difference. MACD is calculated by subtracting one moving average from the other. As a security increases in price, the difference (both positive and negative) between the two moving averages is destined to grow. This makes its difficult to compare MACD levels over a long period of time, especially for stocks that have grown exponentially.

A Negative Divergence forms when the security advances or moves sideways, and the MACD declines. The Negative Divergence in MACD can take the form of either a lower High or a straight decline. Negative Divergences are probably the least common of the three signals, but are usually the most reliable, and can warn of an impending peak.

A Bullish Centerline Crossover occurs when MACD moves above the zero line and into positive territory. This is a clear indication that momentum has changed from negative to positive, or from bearish to bullish. After a Positive Divergence, the Bullish Centerline Crossover can act as a confirmation signal.

A whipsaw occurs when a buy or sell signal is reversed in a short time. Volatile markets and sensitive indicators can cause whipsaws.

For example, a whipsaw would occur if a position trader initiates a long position on a bullish MACD crossover and has to close it the next day because of a bearish moving average crossover. The signal was reversed and the trader had to exit quickly.

A Positive Divergence occurs when MACD begins to advance and the security is still in a downtrend and makes a lower reaction low. MACD can either form as a series of higher Lows or a second Low that is higher than the previous Low. Positive Divergences are probably the least common of the three signals:

1. Positive Divergence
2. Bullish Moving Average Crossover
3. Bullish Centerline Crossover

…but are usually the most reliable, and lead to the biggest moves.

The most popular formula for the “standard” MACD is the difference between a security’s 26-day and 12-day Exponential Moving Averages (EMAs).  Using shorter moving averages will produce a quicker, more responsive indicator, while using longer moving averages will produce a slower indicator, less prone to whipsaws.

Of the two moving averages that make up MACD, the 12-day EMA is the faster and the 26-day EMA is the slower. Closing prices are used to form the moving averages. Usually, a 9-day EMA of MACD is plotted along side to act as a trigger line.

A bullish crossover occurs when MACD moves above its 9-day EMA, and a bearish crossover occurs when MACD moves below its 9-day EMA.

The Merrill Lynch (MER) chart below shows the 12-day EMA (thin blue line) with the 26-day EMA (thin red line) overlaid the price plot. MACD appears in the box below as the thick black line and its 9-day EMA is the thin blue line. The histogram represents the difference between MACD and its 9-day EMA. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.

A Shooting Star sends a warning that the top is near. It got its name by looking like a shooting star.

The Shooting Star Formation, at the bottom of a trend, is a bullish signal. It is known as an inverted hammer. It is important to wait for the bullish verification.