Buying The Dips

11/03/05 02:32:57 PM

by David Penn

The oldest trick in the trend trading book provides entries in Apple.

Security: AAPL
Position: N/A

There's a stock you love. It's going up apparently every day. Everybody is talking about it. And you want in.

If there is a more typical scenario for the average trader, then I'm not sure I've heard of it. Often, this is one of those situations in which a little knowledge can be a dangerous thing. After all, how many traders have seen stocks go up -- sometimes way up -- and refused to jump on for the ride because it seemed that, since everybody already knew that the stock was hot, the stock was due for a terrible correction sooner than later. The superstitious among us probably take that a step further to suggest that such a terrible correction is all the more likely simply because we are about to enter the trade.

FIGURE 1: AAPL. Excellent dip-buying opportunities were apparent frequently during Apple's autumn advance. Both MACDH "dips" and MACDH crossovers from negative to positive (red to blue) signaled opportunities for traders to get long shares.

Graphic provided by: Prophet Financial, Inc.

What fortunate nonsense! There are two ways to trade a trend, generally speaking: One is buy strength and the other is to buy weakness. In the first case, the strength to be bought comes in the form of a breakout above recent highs. Often referred to as the "momentum school," this pedagogy works from the premise of buying high and selling higher.

In the second case, however, the weakness purchased is temporary weakness in an otherwise strong trend. The province of swing traders, this approach to trading the trend is called "buying the dips." For many, not just swing traders, this way of trading has the added advantage of taking positions that are usually less expensive than those taken by momentum traders. This creates a better risk/reward ratio and tends to mean that even those trends that are less than spectacular will nonetheless result in reasonable gains.

One of the things I like about using the moving average convergence/divergence histogram (MACDH) is that it helps pinpoint buyable dips. When used in combination with an intermediate-term moving average like the 50-day exponential moving average (EMA), traders can use the MACDH in a variety of ways to provide specific entry targets during buy-the-dip opportunities. All of the examples here will be limited to the buy side -- which means that prices are trending above the 50-day EMA (or have not made three consecutive closes below that level).

Figure 1, the chart of Apple, shows a number of ways that the MACDH can be used. One of my favorites is the "continuation dip." This happens when a positively trending histogram briefly trends downward before resuming its positive trend. The day (or session) when the positive trend is resumed I refer to as the "reversal day," and that day (or session) can be used to locate a protrend entry. An example of the "continuation dip" occurs in the first half of September, creating a reversal day on September 16.

Another type of MACDH signal comes when the histogram moves into negative territory (shown in red), yet prices refuse to close below the 50-day EMA for any length of time. Because these sort of dips often lead to powerful resumptions of trend, I refer to them as "breakout dips." An excellent example of a breakout dip can be found in the first half of October. The histogram becomes deeply negative -- deeper than it had been in some time -- yet prices for shares of AAPL close beneath the 50-day EMA. When the histogram turns back up, a "reversal day" is created. In this example, the reversal day is on October 13.

Still another signal that can be derived from the MACDH is the crossover signal. This occurs when the MACDH moves from negative to positive. This sort of signal appears in Figure 1 on October 19 to October 20. With October 20 being the day that the histogram crossed over into the positive, October 20 would be considered the reversal day.

I mention the reversal days involved with each signal type because it is the reversal day that helps provide an entry level. There are two different ways of doing this. The first is simply to entry on the first close above the high of the reversal day. So, using the "continuation dip" from September 16 as an example, we had a high of 51.21. The next trading day, Monday, September 19, closed at 52.64. That would be the entry (or, arguably, the open of the following day at 52.99).

The other method involves a little more work. In the other method, I divided the range of the reversal day in half, and add that amount to the value at the high of the reversal day. Using September 16 again as our example would mean dividing the range (1.26) by two to get 0.63, and adding 0.63 to the value at the high of the day (51.21). That makes for an entry at 51.84. Such a trade would have also been filled on Monday September 19.

Compare the likely results from the September "continuation dip" to the October "breakout dip" and crossover signals to get an idea of the opportunities presented by using the MACDH to gauge dip-buying opportunities in this uptrend. While some would have been more profitable than others, it is clear that this use of the histogram is one that traders should consider adding to their arsenal of sound trading techniques.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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