indicator is a mathematical calculation that
can be applied to a security's price and/or
volume fields. The result is a value that is
used to anticipate future changes in prices.
moving average fits this definition of an indicator:
it is a calculation that can be performed on
a security's price to yield a value that can
be used to anticipate future changes in prices.
following chapters (see page ) contain numerous
examples of indicators. I'll briefly review
one simple indicator here, the Moving Average
Convergence Divergence (MACD).
MACD is calculated by subtracting a 26-day moving
average of a security's price from a 12-day
moving average of its price. The result is an
indicator that oscillates above and below zero.
the MACD is above zero, it means the 12-day
moving average is higher than the 26-day moving
average. This is bullish as it shows that current
expectations (i.e., the 12-day moving average)
are more bullish than previous expectations
(i.e., the 26-day average). This implies a bullish,
or upward, shift in the supply/demand lines.
When the MACD falls below zero, it means that
the 12-day moving average is less than the 26-day
moving average, implying a bearish shift in
the supply/demand lines.
28 shows Autozone and its MACD. I labeled the
chart as "Bullish" when the MACD was
above zero and "Bearish" when it was
below zero. I also displayed the 12- and 26-day
moving averages on the price chart.
A 9-day moving average of the
MACD (not of the security's price) is usually
plotted on top of the MACD indicator. This line
is referred to as the "signal" line.
The signal line anticipates the convergence
of the two moving averages (i.e., the movement
of the MACD toward the zero line).
chart in Figure 29 shows the MACD (the solid
line) and its signal line (the dotted line).
"Buy" arrows were drawn when the MACD
rose above its signal line; "sell"
arrows were drawn when the MACD fell below its
Let's consider the rational
behind this technique. The MACD is the difference
between two moving averages of price. When the
shorter-term moving average rises above the
longer-term moving average (i.e., the MACD rises
above zero), it means that investor expectations
are becoming more bullish (i.e., there has been
an upward shift in the supply/demand lines).
By plotting a 9-day moving average of the MACD,
we can see the changing of expectations (i.e.,
the shifting of the supply/demand lines) as
versus lagging indicators
averages and the MACD are examples of trend
following, or "lagging," indicators.
[See Figure 30.] These indicators are superb
when prices move in relatively long trends.
They don't warn you of upcoming changes in prices,
they simply tell you what prices are doing (i.e.,
rising or falling) so that you can invest accordingly.
Trend following indicators have you buy and
sell late and, in exchange for missing the early
opportunities, they greatly reduce your risk
by keeping you on the right side of the market.
As shown in Figure 31, trend
following indicators do not work well in sideways markets.
Another class of indicators
are "leading" indicators. These indicators
help you profit by predicting what prices will
do next. Leading indicators provide greater
rewards at the expense of increased risk. They
perform best in sideways, "trading"
indicators typically work by measuring how "overbought"
or "oversold" a security is. This
is done with the assumption that a security
that is "oversold" will bounce back.
[See Figure 32.]
What type of indicators you
use, leading or lagging, is a matter of personal
preference. It has been my experience that most
investors (including me) are better at following
trends than predicting them. Thus, I personally
prefer trend following indicators. However,
I have met many successful investors who prefer
prices versus trading prices
have been several trading systems and indicators
developed that determine if prices are trending
or trading. The approach is that you should
use lagging indicators during trending markets
and leading indicators during trading markets.
While it is relatively easy to determine if
prices are trending or trading, it is extremely
difficult to know if prices will trend or trade
in the future. [See Figure 33.]
divergence occurs when the trend of a security's
price doesn't agree with the trend of an indicator.
Many of the examples in subsequent chapters
chart in Figure 34 shows a divergence between
Whirlpool and its 14-day CCI (Commodity Channel
Index). [See page .] Whirlpool's prices were
making new highs while the CCI was failing to
make new highs. When divergences occur, prices
usually change direction to confirm the trend
of the indicator as shown in Figure 34. This
occurs because indicators are better at gauging
price trends than the prices themselves.