|Trading educator Alexander Elder stresses the importance of the moving average convergence/divergence (MACD) histogram in his classic book, Trading For A Living. Elder notes that when bars increase in length like the height of the letters m-M, the slope is rising. When the bars move lower in depth like the letters P-p, the slope is declining. Elder assigns capital and lower case letters for the height and depth of the histogram bars that mark turning points in momentum, which can alert a trader to potential shifts in price direction. Therefore, when the histogram is above zero and a change in slope to the downside is occurring, the pattern would resemble m-M-m. And when the histogram is below zero and the slope changes, the pattern would resemble P-p-P.|
|FIGURE 1: SPY, DAILY. After the appearance of a bearish m-M-m pattern on the MACD histogram, a confirming close below the low of that session forewarned traders of a potential shift in momentum on SPY. The stochastic got a bearish cross the day that the pattern received confirmation.|
|Graphic provided by: StockCharts.com.|
|Consider the bullish P-p-P pattern that formed on S&P 500 SPDRs (SPY) in Figure 1. On November 2, SPY bottomed out, forming a spinning top that looks very similar to a long-legged doji. The small real body of the candle causes it to fall into the spinning top category. However, this candle clearly has a long upper and lower shadow with price closing in the middle of the day's trading range, showing indecision among investors. The November 3rd session brought a higher close that caused the MACD histogram (12,26,9) to tick up, thereby developing a bullish P-p-P pattern in early November. |
But the catalyst that transforms this from a bullish signal to a bullish trade is a confirming close and price follow-through. Price must confirm the bullish or bearish signals made on the histogram by either closing above the high of the session when a bullish sign appears or closing below the low of the session when a bearish signal appears.
The following session, after the bullish P-p-P pattern appeared, prices gapped higher at the open, managing to close the session above the previous day's high, thus confirming the pattern. Further, the stochastic (14, 3, 3) hooked back up that same session, offering ample evidence that momentum was shifting. This bullish behavior sparked a sharp rally in the first half of November. The rally in November seen on SPY's daily chart (Figure 1) was impressive, and to all intents and purposes the case seemed to be closed regarding momentum as prices were climbing to new highs.
|But on November 18, the slope of the histogram suddenly changed, getting a bearish m-M-m pattern as prices closed the session with a doji. The downtick on the histogram was an important clue that prices may have stopped, moving higher and in all likelihood about to shift directions. Those bulls holding long positions taken from the P-p-P signal given in early November got a warning to be on the guard for a momentum shift. This warning tipped off astute swing traders to consider closing their positions and start thinking about a short entry. |
The bearish m-M-m setup turned into a trading opportunity for traders who were looking to get short the next day. Immediately at the open, SPY gapped lower and ended up closing the session below the low of the doji, producing a confirming close and follow-through below the place where the bearish histogram signaled occurred. The stochastic confirmed the reversal as well, hooking down and crossing below its signal line. Other signs that a reversal was under way. The gap down also broke the rising trendline from the November low, producing a color change that offered even more compelling evidence that the bulls were beginning to tire.
A trader has two choices in this setup. They can either wait for a closing confirmation to find an entry point by entering the following day after a confirming close or immediately sell short when prices push below the low of the session when the bearish signal occurred. As long as prices continue to fall, the histogram will continue to decline, confirming the downtrend.
|A protective stop should be placed just above the last minor high. If prices rally back up to test the previous high, it will trigger the stop and close the trade. The stop should be set according to the trader's risk tolerance. This bearish m-M-m setup not only allows a trader to enter a position in the infancy stages off a momentum shift, but by entering the position using the guidelines I've described makes for a very low-risk trade. Now there is no sure thing, but exercising discipline in your entry and exit points in both the bullish P-p-P and the bearish m-M-m setups will increase your odds for a successful swing trade. |
|In addition, other clues were present at the time of each of the reversals discussed, affirming that momentum was in fact waning. At each reversal, it is important to note that there were topping or bottoming tails present, narrow range bodies, color change of candlesticks, and a trend reversal.|
In the case of topping tails, it shows that distribution was occurring. The bottoming tail in early November showed that buyers were nibbling at SPY just above the previous minor low made in October. The narrow candle bodies at the beginning and end of the advance revealed that momentum was slowing, and that the odds were greatly increasing that prices were going to shift and move in the opposite direction. The beginning and the end of the trend was validated by a change candlestick color. It is interesting to note that color change appeared immediately after the each of narrow bodies that occurred. This price behavior is common after candles of indecision, as in this case when a doji or spinning top marked the reversal point. Subsequently, the trends were broken either with the color or shortly after a color change occurred.
Click here for more information about our publications!