In our first two installments of this series on MACD we have introduced you to the basic principles of MACD with some simple examples. But understanding the relationship between traders and market synergy is the basis of MACD interpretation, so here we provide examples of the interaction between the moving averages and the histogram.
Epaulette and Slip
The gold braid that hangs off the shoulder of a soldier’s dress uniform is called an epaulette. The first histogram of the “epaulette and slip” pattern looks just like that epaulette. Better than 85% of all chart action produces an epaulette and slip in the MACD histogram. Therefore, it is a worthwhile pattern to learn to identify. The sequence of the epaulette and slip is often the graphic normalcy of the market. It always has the ability to show you where you are at within the timeline of any market you are following.
The epaulette and slip begins as the epaulette crosses the “0” crossover line, and starts to push as the bars of the histogram outrun the fast average. Even though the histogram may initially appear to be weak, the slow average usually commits early. As more and more traders begin to identify the synergism of a move and start to chase it, the position develops a second histogram, which is the slip.
Defining the epaulette and slip provides an insight as to whether the price action is likely to continue. This is not to say that the scenario of the epaulette and slip provides you with a singular probability signal, only that it is an outstanding aid in telling you what is happening with any instrument you may be following and helping provide order in an unstructured world.
Initially the epaulette and slip produces a pushing histogram, but as traders begin to take profits, the move initially appears to stall out. However, the histogram does not really reverse; instead it just seems to catch its breath. This is often a mid-term correction and often produces a pinch in the moving averages.
The epaulette then morphs into a slip as the fast average begins to flank the histogram and to pull the second histogram along behind it. [It is worth noting that a connected slip, after a clear epaulette, provides an excellent mid-term entry when you have a clear pinch.]
Traders begin to view the price action’s failure to retrace as a continuance and identify a new move as confirmed. More and more traders now begin to come aboard once they see the initial move as continuing. The upshot is that everybody is now chasing the bus. The resulting volatility forces the fast moving average beyond the borders of the second histogram. Instead of the fast average pushing the histogram, it now slips along the outside of the second histogram converting it into a pulling move. This means that the traders are now controlling the action and volatility is driving the bus.
The most common epaulette and slip is normally made up of two connected histograms, however in highly volatile markets it is not uncommon to see the price action complete as two separated histograms (see “Epaulette and slip,” below). Even if they are separated, the epaulette and slip is always comprised of a pushing and a pulling histogram. When they are separated they are often connected with a contrary “pimple.”
A divergence displays an imbalance in the relationship between the synergism of the instrument being traded and the last price paid. They occur when an oscillator makes two tests, with the last one being less than the preceding, while at the same time the price action continues to expand (see “Divergence,” below).
Divergences are a forward looking probability signal, which indicate that even though the internals of a move are getting weak, the majority of the traders don’t see it; at least not initially. Normally, for a position to be sustainable, the price and the oscillators move together as the oscillators confirm the last price paid. The bottomn line is that the price paid and market synergy must go in lockstep for a move to be sustainable.
At the same time, when the last price paid and the oscillators stop marching hand in hand, it is a heads-up of a potential price reversal. If price expands but the synergism does not agree, then the price action is probably going to fail. You simply cannot have a sustainable move without price action and market synergy working in sync.
However, when one oscillator sends a signal that market synergism is diverging from the price action, but if the confirmative oscillator shows no sign of agreement it is a warning that the divergence is false and the move before us is likely to continue.
There are two types of divergences: Momentum oscillators and priced based oscillators. Momentum oscillators include Stochastics and Relative Strength Index (RSI). A momentum divergence occurs when the price action reaches a new high [low], but at the same time the moving averages of the oscillator fail to confirm it. Because momentum oscillators are predicated by using volatility in their composition, they are usually the first indicators we have of the over-bought/sold condition of a move.
At the same time, divergences produced by price-based indicators, such as the histogram of the MACD, should complete slightly later than the divergences produced by the moving averages of momentum-based indicators such as the Stochastic or RSI.
This type of divergence focuses on a histogram such as in the MACD, which is best interpreted by its histogram.
A MACD divergence occurs when the price action reaches a new high [low] but at the same time the histogram fails to confirm it. When the histogram fails to exceed the previous extreme on the second try, even though the price action continues to expand, it is an indication that although the move’s synergism is weakening it is not yet confirmed by traders. The histogram indicates that the move simply lacks enough synergy to be able to continue.
A MACD divergence depends on a momentum-based oscillator, such as a stochastic, for confirmation. Conversely, momentum based oscillators depend on a price-based oscillator, such as the MACD, for validation. However, neither can be expected to standalone. In other words, if you intend to use a divergence occurring in the MACD histogram as an execution signal, a divergence of a momentum oscillator, such as a Stochastic or RSI, must confirm it.
Anytime that the synergism of a move denies the price action, something is wrong and market participants will usually flee the market, until the price and synergism get back into harmony. At the same time, whenever both a momentum and a price-based oscillator agree on a divergence, they produce a very reliable probability signal and the success rate of a reversal increases exponentially.
Lastly, it should be noted that many traders use divergences as a singular trading methodology, preferring to ignore everything else in an effort to keep their trade selection simple. Because confirmed divergences are effective, it is a natural temptation to concentrate on any divergence to the exclusion of everything else. Just keep in mind that a divergence does not constitute a probability signal in the purest sense of the word. Rather, they just tell us the present price is not being confirmed by the markets’ synergism. And although divergences are a strong indicator, they are not in and of themselves a singular trading signal.
Blizzards are a very strong MACD histogram pattern. They occur when the fast average blows out at the histogram’s extreme and then continues horizontally, while at the same time the histogram starts to recede.
This chart pattern is akin to the snow blowing up and off a mountaintop. In your mind’s eye, picture an intense ground blizzard blowing snow up one side of a steep mountain. Then, because the wind is so strong it drives the snow straight out from the top, ignoring the lea side of the mountain completely (see “Blizzards,” below). This is analogous to the enthusiasm of the traders remaining unabated, while the synergy of the market begins to fail.
A blizzard is the normal completion of about 70% of all moves. When it occurs, the move is normally finished. This means that a blizzard can be used both as an exit, and as an entry signal. The chances of a blizzard successfully representing the end of a concluding move and being the start of an originating move are better than 85%. Therefore, blizzards are a very reliable probability signal.
It should be noted that divergences regularly occur with blizzards. Nevertheless, a divergence in the MACD must not be considered as being valid unless a momentum style oscillator also produces a divergence. The bottom line is that before you ever pick up the phone, remember that no divergence based on a blizzard alone, is valid until you have another oscillator confirming it.
The pimple is a highly interpretive and oft times confusing histogram. It reflects a move where the histogram forms on the “0” crossover line uninvited. However, the moving averages never really interact with the histogram. It can be described as a naked penetration of “0” crossover line by the market’s synergy, but one that is essentially ignored by the traders. Initially, it may appear to be the start of a histogram, but after a short time, the bars begin to shorten and the histogram begins to reverse towards the “0” line as market belief falters (see “Pimple,” below).
Pimples are a very strong probability signals and often occur when the synergism seems determined to reverse the market, but the traders, as indicated by the moving averages, won’t go along with the plan. Although the fast average may appear to be starting a pushing move when the histogram initially crosses the “0” crossover line, the move normally just ends up being a minor correction of the prevailing trend. Pimples never end up being what you think they should be. However, pimples do provide a fairly solid heads-up for a mid-term entry. If you are looking for a late entry, they can provide a decent place to add to your position, if that is your trading style. The thing to keep in mind is that they seldom indicate strong independent moves by themselves.
It is not unknown for a pimple to precede the final leg of a divergence. An uncommon scenario is to get a strong histogram, a pimple, and then a lesser histogram as the price action exceeds the previous levels producing a divergence.
Before we get into the actual interaction between the moving averages and the histogram it should be noted that occasionally the slow average exits the initial histogram and then promptly re-enters a new connected pulling histogram. This is called a “double punch.”
It occurs when the primary histogram appears to fail and the bars begin to retreat, indicating an initial reduction of the moves synergism. The slow average then exits the initial histogram, apparently confirming that the move is over and that a reversal is imminent. The histogram may even make a small pimple; although it does not do so with any degree of consistency (see “Double punch,” below).
However instead of reversing, additional synergism enters the market and the histogram once again begins to expand. The slow average then re-enters the histogram, and the move then continues back in the direction of the prevailing trend. In the meantime, the fast average normally starts to slip along the outside of the new histogram as the move continues. The double punch is a unique phenomenon of the MACD histogram in a strongly expanding market and it often ends up with the MACD histogram producing an epaulette and slip.
It occurs when the slow average enters the second histogram from the side, as opposed to entering the histogram through the “0” line. The double punch is often a forerunner to a slip and is regularly an indicator that a strong move may be close at hand. It is important that to be worth trading, the slow average must exit the initial histogram on low MACD side numbers.
The slow average should be constantly watched because it will always disclose the general timbre of the larger market. When a double punch occurs a profitable move is normally in the offing. A double punch is almost a guarantee that the price action is going to expand, although only time will tell how strongly. This is an excellent late entry signal that is effective about 90% of the time.
A “scoop” occurs, as the histogram appears to push, with the fast average entering the histogram. At the same time, the slow average may not even attempt to enter the histogram. It usually appears that a pushing move is underway, but the market synergism simply dries up. The histogram then stalls out and the bars of the histogram begin to shorten. The fast average now quits the histogram altogether. In other words, the fast average literally scoops the histogram (see “Scoop,” below).
Anytime the moving averages are not interacting well within the histogram, you may be developing a scoop. The scoop is a strong probability signal and it occurs with a fair degree of frequency. When you see it develop, the best thing to do is to stand aside and just let the market come to you.
At the same time, scoops can provide a decent place to add to your position. A scoop is effective about 95% of the time when you are looking for a mid-term entry.
A pulling move will often develop a “top hat.” Top hats are deceitful little creatures. They start out looking as though they are going to be a vigorous pulling move, except that the moving averages are clearly disconnected from the synergy of the histogram. The fast average seems strong and appears to want to print, but the histogram is stunted. Instead of the histogram joining the averages, the bars hesitate.
It is an indication that although the traders may seem wildly enthusiastic about the move, the synergism of the market does not agree with those who are making all the noise. Top hats always mean trouble and portend a reversal as the histogram completes. This pattern often occurs during an epaulette when you are looking for an honest slip.
As you can see, the MACD is not one simple indicator, but a method to detect numerous profitable indicators when studied in depth.