This column was originally published on RealMoney on Dec. 20 at 11:58 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
It's very important to me to try to help the average trader learn how to use the same information the corporate traders use. One special challenge for many individual traders is figuring out when to enter a particular play; individuals tend to spend a great deal of time on such a decision.
Unfortunately, the most common problem is that they enter the trade near the top and sell near the bottom. They look at a breakout or a new recent high and think, "All right, now it's safe to go back in." On the other hand, these same traders will look at a stock that's making a new recent low and think, "OK, it's time to short." Very quickly, they find that their trades aren't working, and they just don't understand why. So what did they do wrong?
The answer is often quite simple. They don't know how to read divergences on the MACD, which stands for "moving average convergence/divergence." Investopedia.com defines MACD as "a trend-following momentum indicator that shows the relationship between two moving averages of prices." That explains the concept perfectly. But it may help you to know that in the industry, the 12-day and 26-day moving averages are the most widely used. Because of that, I'll review the longer-term and short-term divergences using the 12-day, 26-day and nine-day moving averages.
A Look at the Longer Term
Quite often, a stock will make a new recent high or low, but the MACDs will diverge positively or negatively. For example, if a stock makes a new recent high but the MACD makes a lower high on the chart, that's a negative divergence and indicates that the buying power has diminished.
To see what this looks like in action, check out the following chart of
On the other hand, if a stock makes a new recent low but the MACD has a higher low, that's called a positive divergence. Simply put, it means the selling pressure has dried up. To see an example of this, take a look at
Research In Motion
These types of divergences are called longer-term divergences, meaning they set a new trend for many days, if not weeks or months.
What do they mean for your trading? Well, while you're buying at the new high, you really should be shorting, and while you're shorting at a new low, you really should be buying. Not understanding how these divergences work can cause you the biggest headaches of your trading life.
Taking Apart the Short Term
Another powerful weapon in the world of divergences is the short-term type. This deals strictly with the fast or positive line (the 12-day moving average) vs. the slow or negative line (the 26-day moving average). No matter where you find the chart, the positive line is always the thick line, and the negative line is always thin.
Many folks use these moving-average lines to trade. Here's the key to using them. When the thick (positive) line runs above the thin (negative) line, it's positive, and the trend for that stock is higher. Conversely, when the thin (negative) line runs above the thick (positive) line, the stock is trending lower. Stay with the trend until the lines cross back the other way, at which time you'd close out the original trade and play the new pattern in place.
In other words, when the 12-day moving average is trading above the 26-day moving average, it's a good time to go long. And when the 26-day moving average is trading above the 12-day moving average, it's a good time to go short. Conversely, it can signal good selling points for long plays, or favorable times to cover shorts.
Understanding how to use divergences is perhaps the single most powerful tool for your trading arsenal. You can also use them when reading other important technicals, such as stochastics or the relative strength index, or RSI. However, it is best to use divergences on the MACD and use these other technicals in a secondary fashion.
Reading divergences allows you to understand when an individual stock or index has made a significant top or bottom, which can help you get in at the bottom and get out at the top.
In my work, MACD divergences are the cornerstone of my evaluation of a stock or an index. Once you become adept at reading them, you can use them in conjunction with other technicals and fundamentals to enhance your trading results, which I'll discuss in upcoming columns.
At the time of publication, Steiman had no positions in any of the stocks mentioned, although positions may change at any time.
Jack Steiman is president of TheInformedTrader.com, for which he also conducts live seminars, and Steiman New Research Group, LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Steiman appreciates your feedback;
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