This technical analysis-based assignment was written by Stockpickr member Ira Krakow.
One of the most common problems that a stock technician
faces is that not all buy or sell signals are genuine. A signal, such as a bullish candle on a one-minute
candle chart, a stock price crossing its 20-day
moving average, or the price touching the upper
Bollinger Band, may be only a temporary blip. The very next minute, the price might reverse sharply. Placing a buy order relying on one indicator over a short time frame -- a "false positive" -- could result in a big loss. Enter the "MACD."
A Look at Capital One's Chart
Technicians use the MACD (Moving Average Convergence/Divergence) either to confirm the potential buy or sell decision (a "convergence") or to detect a false positive (a "divergence").
Here's a daily candle chart for
Capital One Financial (COF Quote - Cramer on COF - Stock Picks) (Jan. 14, 2008 to Feb. 13, 2008), with its MACD graph below the chart.
The MACD statistic is based on the exponential moving average (EMA), a refinement of the moving average, which gives more weight to recent prices than older prices. This is more in keeping with the real ebb and flow of the market than a simple moving average, which treats all prices equally.
When making a buy or sell decision based on history, you care more about what happened yesterday than two months ago, although you don't want to ignore older prices altogether.
Check out the MACD graph (below the candlesticks) in the Capital One chart. Take note of the blue line, the red line and a solid black area. The blue line represents the difference between the stock's 26-day EMA and its 12-day EMA. If the price has been in an uptrend in the last 12 days, compared with its movement in the last 26 days, the upward move has momentum. The black area, the difference between the two EMAs, graphically shows this momentum. The black "mountain," starting grow on Jan 24, shows that the upswing in Capital One is strong.
The MACD can also tells us when to buy. The red line, technically the 9-day EMA of the MACD, is called the "signal line" because when the blue line crosses it, a buy or sell signal is generated. On Jan. 23, the blue line crossed above the red line, creating a buy signal. On Feb. 11, the blue line crossed below the red line, creating a sell signal, with the price descending from the mountain into the valley. If you obeyed these signals, you would have ridden up Capital One from $40 to $48, for a nice 20% gain. The chart below shows the MACD with those buy and sell and points.
The Mountain Top
You could have actually done better. The black mountain between the buy and sell points shows that momentum increased until Feb. 1 and then decreased until Feb. 11. A great trade would have been to sell on Feb. 1, when the mountain was at its peak. That trade would have netted you a cool 40% gain, from $40 to $56. Here's the picture:
In the real world, you would have probably sold a bit later, most likely, on Feb. 4, when the falling momentum of the MACD confirmed the bearish (grey) candle. Still, that would have been a great trade too. The idea is to sell as soon as the price starts to slide down the momentum mountain.
To learn how to view the MACD on your own, check out the appendix at the end of this assignment.
Your MACD Assignment
Your assignment this week is to extend this MACD analysis to other stocks in the banking sector. Why banks? Since bank stocks are very volatile
these days, we might be able to spot opportunities for a quick profit. The task: find the best bank stock for a short term trade.
Stockpickr Staff
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