Coaches Corner

Fibonacci Retracements Part 2

Last week I introduced the concept of Fibonacci numbers and Fibonacci ratios. We then looked at how stocks quite often have a tendency to retrace or pullback by an amount equal to a Fibonacci ratio before resuming their trend. If you didn’t read that article, you need to do so before reading this article. You can read that article by clicking here.

As a brief review, we look for a stock, after an extended move, to retrace (or move in the opposite direction) by either 38.2%, 50% or 61.8% (additionally, 23.6% and 78.6% are looked at as Fibonacci levels as well).

The chart below of Union Pacific Railroad (UNP) shows such a retracement.

ou can see how the stock trended higher from March to May. The stock then pulled back, right to the 61.8% Fibonacci retracement level, then buyers came in and pushed it to new highs. This is an example of how markets and stocks move; they surge, then they pause, then they surge again. During the resting period, stocks and markets often retrace back to a Fibonacci level. Learning how to use these Fib levels might help you improve your entries.

One thing I want to point out on the chart of UNP above is how the stock went 3 Green Arrows soon after bouncing off of the 61.8% Fib level. A trader could have been successful by using the 3 Green Arrows, but the trader who used the Fib level for an entry would have made a little more money. Entering at the Fib level means you’re not entering on a 3 Green Arrow, therefore, you need to know that there is additional risk without this confirmation. You need to ask yourself if this style of trading is for you. If not, that’s fine, but you can still use Fibs to help confirm your 3 Green Arrow entry.

Fibonacci Entries
Fibonacci’s are not magic. They will not guarantee that you won’t lose money. They are just a tool to help you find a possible entry. In order for Fibs to work, you need certain elements in place. The first is a trend, or a significant move in one direction. Once that move has come to end, and a retracement looks to have begun, you can put on your Fibs and wait to see what happens.

Let’s take a look at a trade using Fibonacci’s. The chart below is a daily chart of Apple Inc. (AAPL). The stock suddenly took off in April of 2007. Near the end of July, and after a rise of nearly $60 a share, the stock looks to be reaching a top. This is where many traders get trapped into thinking that a trend is over and done with. Trends are more likely to continue than they are to reverse. If AAPL finds support at one of these Fib levels, we could place a trade hoping for at least a re-test of the former highs.

Just start the Fibs at the low where the move began, and end them where the move up ended. I always extend my chart and the Fib lines. Then I can save the chart to my “Saved Chart Pages” file. This way the Fib lines I drew in will remain on the chart and I don’t have to re-draw them every time I access the chart.

Let’s move forward in time and see what happens.

You can see where the move began in April and ended in July. Once it looks like the stock is sure to retrace, or consolidate, go ahead and put your Fibs on the chart to help you.

Just start the Fibs at the low where the move began, and end them where the move up ended. I always extend my chart and the Fib lines. Then I can save the chart to my “Saved Chart Pages” file. This way the Fib lines I drew in will remain on the chart and I don’t have to re-draw them every time I access the chart.

Let’s move forward in time and see what happens.

This set up looks good. A bounce off of the 50% Fib level. A 50% retracement is very common, even traders who don’t believe in Fibs will look at 50% retracements. I know the stock didn’t exactly touch that 50% level, that’s okay. It came close, and sometimes close is enough. The candlestick on this day is a good candlestick and signals a possible reversal. You might prefer to wait for the next day to see how the stock opens before you take a position if you want confirmation that the buyers really are coming in to take control. But for arguments sake, let’s say you enter here at the close at $125 a share. Our stop loss would be placed just below the 50% Fib level, so we’ll set it at $119. A $6 stop loss is a good stop loss on AAPL because it can move $6 easily on any given day If that is too wide of a stop loss for you, you have two choices: 1) buy less shares so you loss will be small, 2) don’t trade AAPL, find one that is less volatile.

Let’s see what happens next.

Stopped out! Oh well, it happens. Nothing works perfectly. But wait, look, we have a green Doji and the stock intra-day bounced off of the 61.8% Fib level. Do we dare enter right after we get stopped out? Yes! If you have a trade set-up according to your rules, it doesn’t matter that you got stopped out earlier in the day. So let’s buy AAPL at the closing price of $117.05 and place our new stop loss right below the 61.8% Fib level at 112 (again, you could wait for the next day to enter for confirmation).

Wow! It worked! This is often the case. You can’t tell which Fib level you’ll bounce off of, so you might get stopped out with a small loss once or twice. But look at how you would have made up for that loss and more with the stock going from $117 to $145 a share.

Where to exit? You could exit when the stock gets back to its former highs, or you could sell when you’re happy with your profits. You could also sell part of your position once you crossed the 23.6% Fib level and then sell the other half once you get to the former high. How you exit should be spelled out in your trading plan.

I also want to mention something else here. In our examples I used the closing price of the day the stock bounced off of a Fib level. I also mentioned that you could wait a day or two for confirmation. You could also have tried to enter intra-day as close to the Fib level as possible. You could have then put a tighter stop loss. You’ll know pretty quick if you are right or wrong. This is harder to do and does require access to the market during the trading day. You might want to use limit orders to try to get as close to the Fib level price as possible. What ever you do, don’t buy at a Fib level and then hold on as the stock drops below that Fib level. Get out of the trade. Usually when you break one level, you’ll at least go to the next. After you break the 61.8% level, there’s a good chance you’ll go all the way back to where the last move began; a 100% retracement.

Fibonacci’s and Earnings
When a company reports quarterly earnings, many large-fund managers will use the report as a guide to either add to their existing positions, or scale them down. Because of this, you can get large moves on the day of the earnings announcement. Often, this move will continue for a few days. But then profit-taking will take effect and the stock will come back a little bit. This is an occasion to go ahead and put your Fibs on the chart to see if you might get an entry because stocks will often run for several weeks after a good earnings announcement.

The chart below shows Owens-Illinois (OI), On July 30th of this year, after the market closed, they came out with a very good earnings report. The next morning the stock gapped up, ran higher the next day, then the profit taking began and the stock backed off. After a couple of days of selling, the stock moved back to the 38.2% Fib level. I started the Fibonacci measurement on the low just prior to the earnings announcement.

On the day it bounced off of the 38.2% level, the stock opened on the Fib level and then buyers came in. This is a green candle, meaning that the opening price is the bottom of the candlestick’s body and the closing price is the top of the body. Let’s look to see what happened next.

We got a good bounce. Notice how the stock found resistance at the prior high where the top Fib line is. This is a good place to take half your position off, because it’s not unusual for stocks to be unable to get past this point. When they do, however, they will often keep going on a great trend.

Are Fibs Magic?
So why do stocks tend to find support at these Fib levels? Is there something magical about them? I don’t believe there is, though some might disagree with me. I think a lot of the reason for stocks finding support at a Fib level is because so many traders use Fibs. It becomes a self-fulfilling prophecy. They all see the Fib level, and when it hits, they all put their buy orders in. The 50% Fib level works very well because many traders, who don’t use Fibs know that a stock tends to pull back 50%, so they look for an entry at that point. There are other theories about the movements of stocks based on mass psychology, harmonics and so called “magic numbers”. You might have heard of Gann or Elliot Waves and a whole host of others including Astrology. These are interesting, but none are completely accurate. None of them are a ‘magic bullet’ that will make you a millionaire by the end of the year.

There are traders who make a good living using one of these many theories and market concepts, not because they are guaranteed to work, but because the trader applies good money management. Controlling losses is the only real ‘magic bullet’ out there. There are many systems and styles of trading, many work a great number of the time. Traders who uses the best system in the world, but don’t manage their money and control their losses will never succeed as a trader for very long. Just because a stock is bouncing off of a 50% Fib level does not mean that you go and double up on your normal position size. You need to control your losses, so that you can still be around to let your winners run.

Going Short
Have you ever played with one of those little rubber balls? You’ll notice that if you stick you arm straight out, let go of the ball and watch it bounce, it will bounce up, but not as high as where you let it go from. It might only bounce up to your waist. This is often what happens with a stock. It will take a big drop, bounce up, but fail to get to where it started, then it will head down again. If you use Fibonacci ratios, you might be able to estimate where the bounce will end.

The daily chart below of Foster Wheeler (FWLT) shows a sudden and sharp decline, but then a pretty strong bounce looks to be developing.

When you have a stock that has moved down, you start your Fibonacci drawing tool at the top or peak price, and you end it at the bottom or low price.

Now that you’ve established your Fib levels, you can wait to see which one acts as resistance.

Look at that! Can’t get much closer than that. This stock found resistance at the 78.2% retracement level. It’s interesting how the day it hit that Fib level, it looked strong. But the next day it totally collapsed and we soon went down and re-tested the lows.

Let’s look at a current chart of Coca-Cola Co. (KO).

The down draft began at ‘A’ and finished at ‘B’. This gives you your starting and ending points for your Fibs. At area ‘C’ we are hitting the 50% Fib level. For several days, the stock tries to get above this level. We see many days with tall shadows at the top, this means that buyers pushed the stock up only to be rejected by the awaiting sellers. Going short as close to the 50% Fib level and placing a stop about $1 or so above would have given you a nice trade so far. As of this writing, we are still pushing down, we’ll have to see over the coming weeks where find support.

Conclusion
I want to stress one more time here that Fibs are no magic bullet that will help you become a more sophisticated trader – even though you sound like a more sophisticated person when you say “Fibonacci” at a party. It will however, give you a reference point for a possible entry point and stop loss placement. Fibs let you know where possible support or resistance might come, but it’s no guarantee. You’ll find that often you come close to hitting the Fib level, but don’t quite hit it. Fibs also work better when confirming your other indicators; especially trend. If you want to know more about how to use Fibonacci retracements, go to any chart, especially a stock that had a trend up or down, and start using your Fibonacci drawing tool. That’s the best way to learn.

-Mark Jackman
Stock Investor Personal Coach

Fibonacci Retracements

Looking at a stock chart, it’s easy to see that no stock moves in a straight line. Even a strong trending stock will have periods of expansion and contraction. Periods of expansion are manifest as movements in the direction of the trend, either up or down. Contractions, often called “consolidation” or “retracements”, are periods where the stock fails to trend or expand. Often, the consolidation or retracement is a move that is opposite or ‘counter’ to the larger trend.

The daily chart below of Mosaic Co. (MOS) shows these periods of contraction and expansion. I’ve circled the areas of contraction (consolidations and retracements), while leaving the periods of expansion alone as they are plain to see.

It’s obvious that the most money is made while the stock is in a period of expansion. However, these periods often don’t last that long and are fast moving.

These periods of expansion and contraction can be also seen on a downward trending stock as we can see in this daily chart of Starbucks Corp. (SBUX).

Again, I’ve circled the areas of contraction/consolidation, leaving periods of expansion clearly visible.

Stocks might trend, but they don’t move in straight lines. However, our success will always be increased by going with the trend instead of going against the trend. Once we’ve identified the direction of the trend, we can look for a possible entry. Many traders prefer to enter on pullbacks or retracements. The problem with a retracement is that it’s hard to tell where it will end. We don’t want to enter on a retracement, only to find out that the stock has further to go before the retracement is finished.

One method that some traders use to find potential entry points during a retracement is by using Fibonacci ratios.

Fibo what?
Fibonacci isn’t a what, it’s a who. Leonardo Fibonacci to be exact. Okay, his real name was Leonardo Pisa (since he came from Pisa, Italy) but somehow his name changed to Fibonacci which a good thing because you sound so much more impressive by saying “It’s a Fibonacci number” than you would by saying “It’s a Pisa number”.

Anyways, Leonardo Fibonacci was born around 1175. He was the son of a customs officer and was actually educated by the Moors in North Africa. He became famous for his mathematical skills. One of his most famous contributions to mathematics came in the form of the Fibonacci number sequence.

Fibonacci proposed the following question: if you were to put two rabbits into a field that had high walls on all four sides, so no rabbit could exit and no new rabbits could enter, then how many rabbits would you have after a certain amount of time? To answer this question, Fibonacci introduced his number sequence which begins with 0. The next number is 1. If you take 1 and add it to 1 you get two. After this step, you add the last number to the prior number, so 2 + 1 and you get 3. Then add 3 to the prior number, that being 2 and you get 5. Add 5 to 3 and you 8. Soon you get the following sequence,

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…

To get the next number in the sequence, you just add 377 to 610 and you get 987.

So, now that we have the Fibonacci number sequence, we can get the Fibonacci ratio. This is done by just dividing one Fibonacci number by the number right before it. So 8/5 (8 divided by 5) = 1.6.

If you take any number greater than 3 in the sequence, and divide it by the prior number, you get 1.6 for the first few numbers, but eventually you’ll start to get 1.618, so 233/144 = 1.618. So 1.618 is a very important ratio number.

Once you have the 1.618, you take its reciprocal, .618 and turn it into a percentage: 61.8%. An easier way to get this number is just reverse the order of the two numbers you are dividing, so take 144 and divide by 233 and you get .618 (don’t worry, this is for background knowledge, you don’t need to know all this).

Now from here the math gets more tedious, a clear sign that someone had a little too much time on his hands. So instead of boring you with math and explanations, let me just say that the following numbers are your Fibonacci ratios expressed as percentages:

23.6%, 38.2%, 50%, 61.8%, 78.6%

However, the numbers you should pay the most attention to are 38.2%, 50% and 61.8%.

These ratios show up all around in nature, in flower petals and pine cones. There are books written about this but you could also do an Internet search if you want to learn more. The actual mathematics is not that important, so don’t worry if it makes no sense to you. All you need to know is how to use these numbers.

So what does this mean?
Many traders apply these Fibonacci (Fib) numbers to trading in many ways. For example, a trader might use moving averages that are Fibonacci numbers rather than non-Fib numbers. This is why although many traders use the 20-day Exponential Moving Average (EMA), many other traders use the 21-day EMA because it’s a Fib number. This solves the mystery as to why we use the 21-day EMA as the default moving average in Stock Investor.

The most popular use of Fibonacci numbers and ratios is to measure the expansion and contraction moves of the market that we talked about earlier in the article. After an expansion period, a stock will often contract or ‘retrace’ by 38.2%, 50% or 61.8% (stocks in very strong trends might only retrace 23.6%). Let’s say a stock moves from $50 a share to $70 a share. By this time, the stock is due for a pullback as nothing moves in a straight line forever. Many traders will look for the stock to come to a Fib level and begin buying at these levels.

In the example above, the stock moved from $50 a share to $70 a share or an increase of $20. By calculating the Fibonacci retracement levels we get the following price levels where we’d would start looking for an entrance:

38.2% = $62.36
50% = $60.00
61.8% = $57.64

A trader would look for the stock to find support at or around one of these price levels, and when it does, they would enter a buy order.

This sounds like a lot of work, fortunately, Stock Investor comes with a drawing tool that calculates these levels for you and marks these levels on a chart. To access this “Fibonacci Retracement” drawing tool, simple click on the drawing tool icon above any chart. Your drawing tools will most likely appear in the lower left corner of your screen (if you don’t have your page monitor on, they will come in the form of a pop-up window.

You can see the drawing tool icon; it’s a picture of a hammer and wrench (Arrow A). The Fibonacci Retracement Drawing Tool is a series of horizontal lines (see arrow B). To use the tool, click on the Fibonacci Retracement icon, then put you cursor at the point you wish to begin drawing your Fib levels, click once, then move your cursor over to where you want it to end. To measure retracements that are part of an uptrend, you start at a significant low, and end at the most recent high.

One the daily chart of Celgene Corp.(CELG) below, I’ve pointed to the $40 low that the stock formed before moving higher. You draw the line from the low to the high. I also will extend my Fib lines to the right so that I can watch for future moves.

It’s obvious that CELG has made a near-term top. We can use the Fibs to help identify a possible level of support. I’ll put the Fib lines on my charts and wait to see if the stock finds support at one of these levels.

Let’s see what happened next.

At first, it looked like the stock was finding good support at the 38.2% level, but it eventually made its way to the 50% retracement level where buyers began to nibble more earnestly. Let’s go forward a few more weeks.

Buying at the 50% retracement level would have made a great entry as the stock took off to new highs from there. The stock trended higher, gave up half of its gains, and then went onto new highs.

I want to point out something on the chart of CELG above, as the stock bounced off the 50% Fib level, the stock also went 3 Green Arrow. Even if you don’t use Fibs, you don’t miss trading opportunities and I want to make it clear, because often, when a stock resumes its upward trend after a retracement, it will go back to 3 Green Arrows, so you don’t really need to use Fibs. They are just another confirmation tool.

Let’s look at some more.

Below is a weekly chart of International Business Machines (IBM). Each candlestick represents a week’s worth of data. As you can see, the retracement principle works on weekly charts just as well as it does on daily charts (in fact, day-traders will use Fibs on 5-minute charts or whatever time frame they use).

The trended began in Jul of 2006, and lasted until October of 2007. IBM would eventually retrace 50% of that move; find support and then move on to new highs.

Our next chart is a daily chart of Gamestop (GME) during late 2007 where the stock enjoyed a nice uptrend. GME would only retrace 38.2% before it began to return to making new highs.

I personally like it when stocks retrace back to the 50% level because I feel that it has shaken out more of the weaker hands, but when a stock only retraced 38.2, it shows that buyers are impatient and can’t wait to get in. You normally get these smaller retracements when a stock is in a powerful trend.

Below is a daily chart of Mosaic Inc. (MOS). There was a sudden and sharp pullback earlier this year that just happened to stop dead at the 50% fib level (see circle) and then shot up to new highs.

Fibonacci levels work on down trending stocks as well. With a down trending stock, you will start your Fib drawing tool at the most recent peak and connect it to the most recent low. What you are doing with these is trying to predict how high the stock will bounce before it begins to move down again. Let’s look at Mosaic Inc. (MOS) once again for an example of this.

You start at the high of about $163. connect to the most recent low. Leave the Fib lines on the chart to see where the buyers run out of steam and where the sellers take control again.

Let’s see what happened over the next several weeks.

The stock came right to the 61.8% retracement level and the rally was finished! You might have noticed that it went a little bit through the 61.8% level by a few dimes, that’s okay. It still worked, and that’s what is most important.

Conclusion
I know this all seems a little complicated and mathematical, but you don’t need to work too hard on this. Just understand that when a stock trends in a direction, it will often take a pause and give back some of that gain. Often, the stock will retrace to one of these Fib levels, where buyers will begin entering and moving the stock to new highs. That’s all you need to understand. The same works on downward trending stocks, often the stock will bounce back up 38.3% or 50% or 61.8% before resuming its downtrend.

Next week, we’ll look more into trading with Fibs.

-Mark Jackman
Stock Investor Personal Coach

EMA Crosses

One of the most common questions I’m asked is “What do all those searches in Stock Investor mean?” I’ve mentioned several in some of the past articles, but I still get questions. So today, I think it would be a good idea to look at one group of searches: the EMA crosses. If you’re looking at the the Pre-Computed Scans page, you’ll see the four EMA cross searches just below the 3 Green and 3 Red Arrow searches.

There are two EMA Bearish searches and two EMA Bullish searches. There are usually many more stocks in these searches than there are in the 3 Green Arrow and 3 Red Arrow searches.

EMA is short for Exponential Moving Average (for a review of moving averages, click here). Bullish and Bearish indicate the potential direction of the stock, “bullish” means we’re looking for the stock to move up, “bearish” means we’re looking for the stock to move down. These four searches are looking for moving average crossovers. Many traders use two moving averages crossing over each other as potential buy and sell signals.

The numbers in the search represent the two moving averages that are crossing over. For short-term and intermediate-term traders, we have the 10-day EMA crossing the 50-day EMA (10-50), and for the longer-term traders we have the 30-day EMA crossing the 200-day EMA (30- 200).

The concept behind a moving average crossover is that it reflects a change in the near-term momentum compared to the the longer-term momentum. When the faster moving average (the lower number EMA) crosses above the slower moving average (the higher number EMA), then you have a potential buy signal. The ‘EMA Bullish Cross 10-50′ searches for stocks that have their 10-day EMA crossing above their 50-day EMA. The 10-day EMA is the fast moving average and the 50-day EMA is the slow moving average.

Below is a chart of the Powershares QQQ Trust (QQQQ) which is an Exchange Traded Fund (ETF) that tracks the NASDAQ 100 index. You can see a couple of Bearish Crosses where the 10-day EMA (blue line) crosses below the 50-day EMA (red line). The lone Bullish Cross shows the 10-day EMA crossing above the 50-day EMA. Just following the moving average crossovers would have done well over this period of time.

The ‘EMA Bullish Cross 30-200′ searches for stocks where the 30-day EMA (fast moving average) is crossing the 50-day EMA (slow moving average). Please note that ‘fast’ and ’slow’ are relative. If I’m trading with a 10-day EMA and a 21-day EMA, then my 10-day EMA is ‘fast’ and the 21-day EMA is ’slow’; but if I’m trading with the 21-day EMA and the 50-day EMA, then my 21-day EMA is my fast moving average while the 50-day EMA is my slow moving average. What’s important is that in any two moving average, one will be faster than the other.

The chart below is a daily chart of Boeing Inc. (BA). I’ve had to really scrunch the information in so that you can see enough data. Because the 30-200 is a longer term trading set-up, traders who use these slower moving averages will be in trades for quite some time.

A trader who trades these slower moving averages will catch these long-term trades. On the chart of BA above, if you just traded the crossing of the 30-day EMA (pink line) and the 200-day EMA (brown line), you would have made a lot of money. The first Bullish Cross on the chart occurs when BA is trading around $35 a share. We get a Bearish Cross at $74 and then quickly get another Bullish Cross at $76 and the final Bearish cross occurs around $90 a share. However, you might have noticed that being a longer-term trader means that you have to sit through some really mean pullbacks. In 2006, BA went from $90 a share to close to $72. Longer term trading has some great rewards, but too many traders don’t have the patience to wait for their proper exit signal and they end up getting out too early.

So What do the Searches Mean?
If you want to incorporate moving average crossovers into your trading, then you’ll want to use these searches. You will use the Bullish Cross searches for stocks to buy, and the Bearish Cross for stocks to sell short, if you are a trader who likes to short stocks.

You do not want to just buy any stock because two moving averages are crossing. You need to have rules as to how you will enter and exit a trade. Don’t just buy a stock on a crossover because you read about crossovers in an article. Use the Walk-Thru Tool in Stock Investor to help you back test a moving average crossover system. Write specific entry and exit rules. Forward test the strategy by paper trading several times successfully.

When deciding on rules, you’ll need to decide what two moving averages you will use. Will you enter the day after the crossover or will you wait for the first pull back to a certain moving average (like the 21-day EMA)? Will you enter only after you make a new high from the crossover point or do you wait for a 3-Green Arrow confirmation? Do you exit on the bearish cross, or will you use trendlines to help time your exits? All these questions should be answered in your trading plan.

If anything, these searches could be used to help build a watchlist for whatever style of trading you do. For example, you might not use moving average crossovers at all in your trading, but you could still look at the stocks that show up on these searches to look for ideas for the type of trading that you do.

If you want to buy when the 21-day EMA crosses above the 50-day EMA, you will use the EMA Bullish Cross 10-50 to find potential candidates. You’ll just have to wait a day or two before the 21-day EMA crosses over the 50. The same thing applies to a trader that likes to buy when the 50-day EMA crosses the 200-day EMA. That trader would use the EMA Bullish Cross 30-200 to find set ups as the 30-day EMA will crossover the 200-day EMA several days, maybe even weeks before the 50-day EMA crosses the 200.

Variations
Moving average crossovers themselves are not without their misgivings. You will have noticed from the charts above that you often get a sell signal well after the top has been reached in a stock and you end up giving back a large amount of your gains. Also, in a non-trending environment you can get whipsawed quite a bit. Having good rules will help you minimize much of these problems.

Because of these weaknesses with crossovers, many traders have come up with various different ways to construct a moving average crossover system. For example, you could buy when the 21-day EMA crosses over the 50-day EMA, but sell when the 10-day EMA crosses below the 50-day EMA (or even the 21-day EMA for earlier exits). Let’s look at an example of this by looking at this daily chart of Freeport McMoran Copper and Gold (FCX).

In early April we get the 21-day EMA crossing above the 50-day EMA, This is our buy signal, at this point the stock is trading at $100 a share. In early July we get the 10-day EMA crossing below the 50-day EMA, at this point the stock is trading at about $109. Not a bad return. But you might have noticed that in early June, we got a better exit signal from the 10-day EMA crossing below the 21-day EMA when the stock was trading at $112 a share.

This example shows why back-testing using the Walk-Thru Tool is so important. In hindsight it’s always easy to see what the exit signal ’should’ have been. What we as traders need is a clear exit signal before we get the signal. If you sell when the 10-day EMA crosses below the 21-day EMA, you will find yourself buying and selling more often than you probably want, you’ll be exposed to a few more whipsaws (sell signals, followed closely by another buy signal) and you might even get shaken out of trades too early. However, if you are just trying to capture a quick swing, it might work well for you.

If you decide to sell when the 10-day EMA crosses below the 50-day EMA, you will find yourself staying in trades longer, but you’ll also give up more of the gains from the top of the trend because the lag time is the moving averages is slower.

Conclusion
Stock Investor is built around the 3 Green Arrow system, but because moving average crossovers are so popular, we have 4 searches that will help you find moving average crossover set-ups. You will want to become more familiar with moving averages and how you can use two moving averages to find potential trades. The Coaches Corner ran a 3-part article on moving averages several months ago. Although I included a link to that article above, I’ll include another link here. Read those articles and then come back and read this article again. If you want to use moving average crossovers, make sure you have a system in place and rules written down so that you know exactly where you entries and your exits are.

-Mark Jackman
Stock Investor Personal Coach

Two Green Arrows?

Stock Investor is a very powerful search and research tool with the 3-Green Arrow search being the cornerstone of the 3 Step Investing Process. The 3 Green Arrows are produced when a stock crosses and closes above the 21-day Exponential Moving Average (EMA), the MACD line crosses above its signal line, and the Stochastic crosses its signal line all on the same day.

Below is daily chart for Mead West Vaco Corp. (MWV). On July 17th, the stock went 3 Green Arrow and since, it has continued to climb.

This really isn’t the greatest example, the 3 Green Arrows occurred in a downtrend, but as oversold as the market has been, this stock and a lot of others had some pretty good bounces in them.

The 3 Green Arrow search displays all the stocks that produced Green Arrows on all three indicators on that day. If a stock only gave us 2 Green Arrows, it won’t show up on the search. This is because the signals tend to be stronger when they occur at the same time rather than on different days. However, many stocks begin strong trends without going 3 Green Arrow on the same day. Often, the arrows come a few days apart. You want the arrows to be as close as possible; the closer the better.

So how can you find stocks that only have 2 Green Arrows that day? Believe it or not, there is a way to search for these in Stock Investor.

Expanding the Searches

Let’s look at a screen shot of a typical search page.

On this day, there were 8 stocks that produced 3 Green Arrows. Often, however, you might only get one or two or even none. If you are unhappy with the results for that day, you can actually expand the search to find stocks that have only 2 Green Arrows that day. This will give you more stocks to look at.

On the screen shot above, you might notice 3 columns, titled “EMA”, “MACD” and “Stochastic”. Under each column for each stock is the word “True”. This means “True, the EMA went Green Arrow today. True, the MACD went Green Arrow today and True, the Stochastic went Green Arrow today. Three trues; 3 Green Arrows.

If you put your cursor over the column title, “EMA”, “MACD” or “Stochastic”, a little down arrow will appear.

I’ve circled that little arrow that appears when you put your cursor over that particular box. If you click on the little down arrow, the following menu will appear.

I clicked on the “EMA” box. There are 3 choices presented on this drop down menu, “All”, “Custom” and “True”. You’ll notice that “True” is already selected. “Custom” is something we’ll ignore. But if you click on “All” you will suddenly get more stocks showing up on your search page because what you’ve done is you’ve told Stock Investor to display all stocks that have the other 2 indicators producing Green Arrows, whether or not they are producing a Green Arrow on the EMA (or which ever indicator you chose).

Now you have a bigger list! You’ll notice that many of the stocks don’t have the word “True” under the EMA column. This is because these stocks didn’t produce a Green Arrow this day, only Green Arrows on the MACD and Stochastic. These stocks might have produced a green arrow on the EMA a few days ago, or it might not yet be ready to go Green Arrow. By expanding the search like this, we can start putting together a good watch list of potential trades.

If the stock went Green Arrow on the EMA a day or two ago, and not it’s going Green Arrow on the MACD and Stochastic, you now have a stock that is 3 Green Arrow and could be a potential trade. Remember, the stock doesn’t need to go 3 Green Arrows on the same day, just withing a few days of each other. The closer the Green Arrows are to each other, the better and more powerful the signal.

Let’s look at a couple of the stocks on our list.

The chart above of Aerovironment Inc. (AVAV) is a good example of what this search can find. You have a stock in a near-term upward trend making higher highs and higher lows with good volume pushing you up. The stock last produced a Green Arrow on the EMA back in June. Since then, the stock has remained above the 21-day EMA, like a strong stock should. On a recent pullback, the MACD and Stochastic both went Red Arrow, no big deal. Remember the trend is more important than the indicator; an upward trending stock often goes Red Arrow on pull backs. As long as the stock stays above its trendline or 21-day EMA, it’s okay. Sure enough, the stock only pulls back a little, then the buyers come back in. This produces fresh new arrows on the MACD and the Stochastic, another possible entry point.

Our next stock, however, is something that would be best avoided.

Above is a daily chart of Nucor Corp. (NUE), the stock has come down quite a bit from its highs. Although the MACD and Stochastic has gone green arrow, the price is still trading below the 21-day EMA, so no Green Arrow there. Even if this stock was giving 3 Green Arrows, it probably wouldn’t be a good candidate for a buy because of the series of lower highs and lower lows that it is making. Furthermore, the 21-day EMA is still trending down; not a good sign. I also don’t like to buy when the 21-day EMA (green line) is trading below the 50-day EMA (red line). Remember, the trend is more important than the indicators, and this is in a near-term downward trend and it doesn’t appear ready to change any time soon. Just as an upward trending stock can have pull backs, downward trending stocks can also have bounces. These bounces usually don’t last long and soon you are making new lows again. In fact, that is the case with NUE, let’s see what happened a few days later.

I’ve put an arrow at the point where the first chart left off. As you can see, the 21-day EMA acted as resistance and the selling came in pushing the stock to a new low. This is why you have to follow the trend and wait for that confirmation of the third Green Arrow. NUE didn’t have an upward trend, nor did it have 3 Green Arrows.

Conclusion
Above, I changed the EMA from “True” to “All”. You can change the EMA back to “True” and then change one of the other indicators; MACD or Stochastic to “ALL” to see what other opportunities you might get. Often, the MACD lags the other two indicators a bit, especially on a bounce off of a support level. The Stochastic will also go Green Arrow a day or two before the other indicator. Trying a few different settings will get you different results. You shouldn’t need to have more than one indicator on “ALL” however. If you’re not getting results by changing just one indicator to “ALL”, it’s probably a sign that you shouldn’t be buying anything at that time.

Also, you can do the same thing on the 3 Red Arrow Search.

By expanding the 3 Green Arrow search, you can find trading opportunities. Some of the stocks might be ready to trade right now, others will be watchlist candidates. Either way, by expanding the 3 Green Arrow search to find stocks that have only produced 2 Green Arrows on a given day, will give you more candidates for potential trades.

-Mark Jackman
Stock Investor Personal Coach

Help!

Today I wanted to show you a little known feature in the Stock Investor software, it’s called the “Help Menu”. Yes, there is a feature built into Stock Investor that will answer most all of your questions about the software. If you have questions about search parameters, indicators and general ‘how to’, the answers can be found in the Help menu. The Help menu is located at the very top of the software, no matter what page you are on (see below).

I’ve circled the ‘Help’ menu button. To access the Help menu, simply click on where it says “Help” and you’ll see the following drop down menu.

As you can see, there are a few options under the Help menu. From here, you can access the “Contents” portion of the Help menu (we’ll focus on this later), you can see the “Tip of the Day” just in case you missed it when you logged into your software. There is also a link right to the Stock Investor website. This is very handy when, after doing your research, you want to place a virtual trade on the Stock Investor website (www.stockinvestor.com). Just go to the Help Menu and choose the “Stock Investor Website” option to go straight to the website where you can place your virtual trade.

Finally there is the “About” option that tells you which version of Stock Investor you are currently using (Note: there is also a link to the Stock Investor website from this page as well).

Let’s now focus on the “Contents” portion of the Help menu. When you go to “Help” then click in “Contents” a pop-up box like the one shown below will appear,.

This is the Contents Main Page. I’ve circled the 3 navigation tabs that you’ll want to be aware of. You’ll notice that the first tab is simply called “Contents” and a brief outline of the major sections of the help menu are displayed. If you click on the ‘+’ sign to the left of each subject, a sub-menu will appear.

In the figure above, I have clicked on the “Scans” sub-menu. This gives me more specific subjects. If I was looking to find information on the different types of scans in Stock Investor, I might first click on the “Pre-computed Scans Overview”. Let’s see what that give us.

A brief article describing the Pre-computed scans will appear. The Help Menu is rather large and detailed, you could spend hours going through the different entries. Some entries will have links to other entries.

If you don’t see what you need under the Contents tab, then you can go to the “Index” tab.

As you can see, there are more subjects and options to choose from under the Index tab. All you need to do is click on any of the headings on the left side of the screen and the articles will appear in the main portion of the pop-up box.

Finally, if you don’t see what you’re looking for, or you don’t want to look at a bunch of different topics, you can go right to the source and do a search by clicking on the “Search” tab.

I usually use the Search tab because I can find things quicker. Above, I did a search for “Moving Averages”. All the articles that mention moving averages will be displayed on the left side of the screen. There are some really good explanations about each indicator; including how they are calculated and how they are often used by traders. There are articles explaining the different parameters of each of the Pre-built searches. You can even find out how to use the fundamental rank and if you have any questions about what’s on the company profile page, the answer can be found in the Help Menu.

Let’s say you wanted to find out what “Net Income” means, since it shows up under the company profile. You can go to the Help Menu, do a search for “Net Income”. This search will lead you to an entry for “Company Profile” where it discusses what Net Income is.

The help menu contains a wealth of information. Many of the questions I get ask daily can easily be answered in the Help Menu. It’s a great resource, not only in learning how to use the Stock Investor software but also it will help you to learn what is available to help you in your trading.

-Mark Jackman
Stock Investor Personal Coach

Update on the Markets

I thought it would be a good idea to take a little break from our normal coaches corner article and instead, take a look at the markets. The trading environment has been really difficult lately. The markets have been in decline and bad news is just everywhere. Sometimes, it’s just too easy to miss the forest through the trees.

First of all, let’s look at the trends of the market. I’ll be using the S&P 500 (SPX) to represent the broader market.

Below is a daily chart showing the last several months. I don’t need to tell you they’ve been mostly down, that’s been all over the news.

Let’s pull back a little bit. The chart below is a weekly chart of the SPX. It shows a large deal of volatility since July 2007.

I’ve drawn channels on the chart above. You can see the nice upward channel that was being followed only to have a new downward channel form since October. As of this writing, we are near the lower channel line. Often, when you are at the lower trendline, you bounce back to the upper trendline. However, you can stay near the lower trendline for quite some time before making the move to the opposite end.

I want to now zoom out even more. Let’s look at a longer time frame to get a different perspective.

This chart goes back to 1887. The crash of 1987 is just barely visible on the most left side of the chart. You can see how the S&P 500 followed a nice gradual trend until 1995, when it just took off at a much steeper angle. The tech bubble is clearly visible as is the popping of that bubble from 2000 to 2003. Notice the long bottoming process between 2002 and 2003. The bear market there didn’t just end abruptly, instead, a base was formed from which the market exploded out of. We just barely topped our 2000 highs in the SPX last year when our most recent bear market began. But you can see from this that there is an overall upward bias to the market. The market sometimes gets way over bought, but then it comes back down and proceeds to go higher. I don’t know if this bear market is going to be short or if we’ll retest the lows from 2003. What I do know is that we will one day have a great bull market again.

The point of showing this chart to you is to let you recognize that although the market can have some serious declines, it does have an overall upward bias. And although there is a general trend, it never just goes straight up or straight down. There are some reasons for this zig-zag type of motion to the markets, and understanding such market mechanics will help you to become a better trader.

Channels
The market, as well as stocks will move in channels. Some are major channels, some are minor or sub-channels. It’s important that you use longer-term charts, such as weekly charts, to identify many of the major channels. The chart below is a daily chart of the SPX since last October. You can see the major channel, but inside, you’ll see several sub-channels that are formed as the market goes from one end of its channel to the other end.

Let me just mention one thing here. Generally, in an uptrend, the lows are easier to connect than the highs. A good uptrend usually has the lows line up nicely, which is why it’s best to draw the support line connecting the lows first. The highs in an uptrend can be quite irregular and placing the resistance line at the peaks to form a channel can be challenging. The same goes for down trends, except it’s the highs that line up the best while the lows do not, making it often difficult to decide where to place that lower channel line. That is the case above, I honestly can’t find a place for that lower channel line that fits right, so I might move it at some point when more information is available. Remember, the lines are there to guide and help us, they are not magical and they don’t always hold prices.

The Extremes
While the market has been in a downward trend, several areas of the market have experienced strong bull markets. Of course I’m talking about oil and energy related stocks, as well as some mining stocks, steel, coal, railroad and agriculture stocks. These have been going up for quite some time. However, lately, there has been some signs of distribution in these areas, meaning big money is leaving. This doesn’t mean that these stocks are going to go straight down, they just might enter an area of consolidation. This often happens after large run-ups in price. If you start looking at longer-term charts, you’ll see that stocks often move in this surge-consolidate-serge fashion.

The chart below is a weekly chart of National Oilwell Varco (NOV). It goes back a couple of years. You’ll notice long periods of consolidation that could have been very frustrating for traders even though the overall trend remained strongly to the upside. Obviously, the most money is made in the surge areas. Unfortunately, they often don’t last as long as the consolidation areas.

It’s important to always look at longer-term charts to identify if you are in a surge mode or a consolidation mode. You can still trade a stock that is in a consolidation period, some of these ranges inside of a consolidation could be ten or even twenty dollars or more! You will however, need to be more careful of the resistance levels that will be present when consolidating.

Looking back at that chart of NOV, you may notice that the stock will get so far overbought, that it will pull back, often violently, even though it’s in a long term up-trend. This is why it is so important to use stop losses, you don’t want to hold through a $20 correction. Your indicators will alert you to when you’re over-bought. The chart below looks back in time a little on NOV to where that last consolidation period began.

There are some signs of being overbought at the top. The price is far above the 21-day EMA, in fact, it hasn’t tagged the 21-day EMA in quite some time. The MACD is at an extremely high area and now moving sideways. The Stochastic, which in strong trends generally stays at an extreme range, is starting to move slowly down. Now, all these signs don’t necessarily mean sell, because the stock could still go higher before it snaps back. What they do tell us though is that it isn’t the time to enter. It’s been too long and too far in price since the stock went 3 Green Arrow and gave us a good entry point. Yet, people were still buying. Why? Because they feel the stock is strong, it’s been going up for so long. They feel more comfortable buying a stock has been going up for 3 days in-a-row than one that has been going down for 3 days in-a-row.

I mention this because I see it too often. Traders who, having heard about a stock for weeks, and watching it go up endlessly higher, decide to jump in, then the stock pulls back. It is so important to have entry and exit rules written down and followed. If your entry rules say don’t enter when the MACD is at an extreme point and don’t enter if the price is far from the 21-day EMA, then you wouldn’t have entered this trade. Does this mean that you miss some trades? Yes, of course. But I’ll be willing to bet that if you look a little deeper, you’ll always find stocks that are meeting your criteria. If not, just wait, all stocks come back eventually.

I mention this because I’ve seen something similar the last few days. People entering the short side (selling stock short or buying put options) when the market was so obviously oversold. Stocks and indexes have been going down for so long, that the obvious thing to do is join in and go short. But you need to have your entry rules as well. Don’t enter a short when you’re near support, far below the 21-day EMA and your indicators aren’t giving you an entry point. Let’s look at an example. The chart below is of the Financial Select SPDR fund (XLF). This is an Exchange Traded Fund (ETF) that tracks the financial sector. Essentially, this is a fund that has bought a basket of financial stocks so it tracks that sector. Note the signs of extreme selling recently.

There is no doubt that this sector is in a down trend. But let me ask you, how much further do you think it could go? It’s already come down a long way. The best entry has come and gone and won’t come back unless the stock has a nice big bounce. Like the earlier chart of NOV, it was trading away from its 21-day EMA, but in this case it’s below the EMA. It also hadn’t touched the 21-day EMA for quite some time and it was moving further and further away from this moving average. It’s not the time to start entering a short sell.

Remember, stocks and markets don’t move in straight lines. They zig and zag their way to their destinations. If a stock is going to go from $50 to $100 in a 6 month period, it will rocket up, then fall back, move up a little, then move sideways and it will repeat this process over and over again until it reaches $100.

When a stock moves down, it will also have nice bounces only to move down again. A few days ago, it looked like the financials would never go up again. All the news stories were negative, everyone was telling you to stay away from them, yet, look at the bounce they had. Does this mean they are now going to rocket back up to new highs? Probably not, because this most recent bounce is just one of the zags in a down trend. Despite this most recent bounce, the trend is still down, if you buy, you will be going against the trend. When stocks have come down for such a long period of time, they usually form a base for several months or even years before their fundamentals are able to change enough to attract traders and investors again. So although the financials will one day stop going down, it doesn’t mean they will start an up-trend any time soon.

Zig-Zagging along
Why don’t stocks just go straight? Why do they zig and zag? Remember, people have different opinions, so they have different actions. Others have different styles and rules to their trading that make them buy when others are selling. If a stock is moving lower, more and more holders of that stock will sell because they can’t afford to lose any more money. Short sellers will come in, borrow shares and sell them in the market. There comes a time however, where bottom pickers come in, hoping to catch the bottom. Other longer-term investors and value investors accept the fact that they can’t pick bottoms, so they just buy when a stock has come down to certain price, knowing that the stock could still move lower in the near-term but that’s okay because they believe in a year or two or three that the stock will be higher and they are willing to hold and wait for that time to come. Eventually this buying slows the downward surge, the short sellers, sensing the downtrend is losing steam, begin to close their trades. They do this by buying back the stock that they shorted. This is buying and it puts buying pressure on the stock. This competition for stock can lead to very strong bounces.

After the stock bounces, if no new buyers come in, the stock will stall. Holders of the stock who hadn’t sold yet, are happy that they have a higher selling price than just a few days ago, so they sell. They are so disgusted and discouraged by the stock that they just want an out. As this selling pressure takes over, the new investors will often see early profits disappear and they too will exit and soon the stock is back at its lows, and maybe even lower. This process will repeat itself over and over until there are just no more people left to sell.

Let’s look at this in action by looking at the SPX during the bear market of 2000 to 2003.

I’ve pointed out the bear market rallies. Note how long they can last, but also look at how fast they move off of their bottoms. Shorting can be difficult because of this. Bottoms, even temporary and short-term bottoms, are much more violent than tops are. Look at the indicators. They move into extreme low areas before these bounces happen. You don’t want to buy, because that would be going against the trend, and just because your indicators say you are oversold, you can stay oversold for a long time and you can go broke trying to catch the bottom.

You also don’t want to short a stock when the indicators are at extremely low levels because the risk is higher that the stock is going to go against you.

Strong Sectors
Even in a bear market, there are stocks and sectors that move higher. We’ve seen this with oil, energy, steel, coal and agriculture stocks. However, as you go deeper into the bear market, all sectors will sell off. The strong sectors will bounce back sooner, but only after they have sold off. So just because a sector is moving higher while the market is moving lower doesn’t mean that you throw caution to the wind. You have to play defensively.

The chart below shows one of the strong stocks this year, US Steel Corp. (X). Recently, however, large-scale selling has taken place and large price destruction has taken place.

Does this mean the uptrend is over? Maybe not the long-term trend, but the near term trend is now bearish and the stock is yet to show signs of finding a support level.

Another hot sector has been oil and energy. However, that sector has also come down quite a bit. Here is a chart of a popular oil stock, Hess Corp. (HES), and as you can see, some trendlines have recently been broken.

The recent distribution is easy to see. The stock has broken through trendlines, which is not a good sign. Because perspective is important however, let’s look at a long term chart of the same stock.

The long term trend is still in-tact. It’s obvious that the stock got a little bit a head of itself. This chart suggests that in the near-term, it might be toxic to your portfolio. But there might be a day, sometime in the future that you’ll find this stock starting a new up-trend.

As you move out of a bear market, into a new bull market, you will have new leadership. New stocks leading you higher. This means that money will flow out of the stronger stocks that went against the trend of the market the longest, and then flow into sectors that investors believe will be benefiting the most from this new bull market. It’s important to track the sectors and look for signs of strengths in different sectors. Try to find out where that money is going.

Conclusion
The last thing you want to do is to get caught up in thinking that the market should be rational. It isn’t. It will eventually figure things out, but remember, the market is a forward looking mechanism. It doesn’t matter that a stock or sector is having the greatest growth or earnings in its history, if big institutional traders think that it’s time to take profits and put money somewhere else; they will. This is why the trend is always more important than everything else. Always go with the trend. Most oil and energy stocks have been showing signs of weakness the last month even though oil prices were going to new highs. Did this make sense? It does if you realize that it’s supply and demand for a stock that determines price, not news and fundamentals. Investors in these stocks, especially institutions will sell if they feel they’ve made enough profit. This means that there is more supply of the stock and the price is lowered to find willing buyers. Again, let the chart tell you what is going on; trade what you see. If a trade begins to go against you, get out. And always use a stop loss.

Remember, a stock can go down just because it went up too high too fast. A stock can also bounce just because it’s so oversold. These have nothing to do with news or fundamentals. It’s just the way the market works.

-Mark Jackman
Stock Investor Personal Coach

RSI part III: Trading with the RSI

For the last couple of weeks, we’ve been discussing the Relative Strength Index (RSI). The RSI is a momentum oscillator that travels in a fixed range between 0 and 100. If you have not read the prior two articles, please do so, because I won’t be reviewing any of that information in this article, in fact, I’m assuming that you have read those articles and I’ll be expanding on those concepts in this article. To read the prior articles on the RSI, click here and here.

We’ve discussed how the RSI is calculated, how it can give overbought and oversold indications, we also talked a lot about the importance of divergence. There are other ways that some traders use the RSI in their trading and we’ll be exploring a few of those in this article.

Patterns
The RSI is an interesting indicator in that it can often make patters like double-bottom and double-tops. Some traders use these patterns in their trading as well.

The chart below of Bucyrus International Inc. (BUCY), the mining and equipment making company, gives us a couple examples of these patterns.

In area A, a clear ‘W’ shaped pattern appears in the RSI and the price as well. Double-bottom patterns often lead to an increase in price and that is exactly what we had. In area B, another double-bottom pattern formed in the RSI. Although it’s not perfectly symmetrical, that’s okay, the pattern still worked. Also, it might be mentioned this double-bottom occurred after a sizable pull back in price where as the double bottom pattern in area A occurred in the context of a retracement that occurred in an upward trend.

In area C, you see a double-top pattern in the RSI. The RSI twice goes up and tags the 70 level and is rejected both times. This creates an ‘M’ shaped double top in the RSI. At the time, the price action doesn’t look too worrisome. The stock is forming a regular consolidation pattern, but the RSI indicated that something more was happening and a sizable decline was the result.

These patterns by themselves don’t give the best of trading signals, but combined with other indicators, they can be a good confirmation tool.

The next chart shows a rather large RSI double top. This chart is an ETF that tracks the Japanese Over the Counter (OTC) index. The ticker symbol is JOF, and it’s made up mostly of smaller Japanese companies.

The double-top was formed in the RSI in the overbought area. The price action itself didn’t make a double top, only the RSI did. The double-top gave a warning that another decline was soon to come. Most patterns carry more significance if they occur in the over bought and oversold areas of the RSI indicator.

Trendlines
The RSI indicator often forms trendlines just like a price chart. Like a price chart, a buy or sell signal can be given when the trendline is broken.

The chart below of Foster Wheeler LTD. (FWLT) shows how the RSI twice followed a trendline up. This corresponded to an uptrend in the price of the stock itself. You might recall that in last weeks article we talked about areas of horizontal support and resistance that often show up on the RSI, where the RSI will go to certain number and turn up from there. That level is usually higher than the oversold area of 30 when in a bull market. This trendline is very similar, instead of being a horizontal support however, you have a rising support.

I’ve used arrows to point to the places on the price chart where the RSI crossed below its trendline for the first time. You might have noticed how they didn’t get you out at the top. But then again, there aren’t many indicators and methods that get you out at the top, except for pure luck. Of course, you can minimize early exits by combining the RSI with other indicators (something we’ll talk about later in this article).

The next chart shows this RSI Trendline on a daily chart of Allegheny Technology (ATI). Once again, this got you out very early. Need I stress the fact that you should back test, combining different indicators for better performance. Oscillators, especially those that travel in a fixed range (such as the Stochastic) will often get you out too early. Using another indicator, such as the MACD in conjunction with the RSI will help keep you in the trade longer to pick up larger portions of those trends.

Just by eyeballing this chart, you could probably see that you’d have better luck following a trendline on the price action rather than a trendline of the RSI.

Combining Indicators
I’ve mentioned the need to use other indicators with the RSI to confirm buy and sell decisions. It’s really hard to trade just with a moving average, or the MACD or the Stochastic, but by combining these three indicators, you get a very good system to help identify potential trades. The chart below shows Apple Inc. (AAPL) using the 21-day Exponential Moving Average (EMA), the RSI and the MACD.

I haven’t marked all the potential buy and sell signals given by each indicator, instead, I’ve circled some sell signals that all three indicators gave in mid-May. All three were close together in time. You might notice that they are all now giving buy signals, we’ll have to see how this turns out. No system is fool-proof, that is why we have stop losses.

The next chart shows a similar situation.

The chart above is a daily chart for the electronic retailer Best Buy Inc. (BBY). This is back in 2005, when retail was a little healthier than it is now. I’ve put my crosshairs vertically on the day when the RSI broke its trendline. The RSI was above 75 and turning down and the MACD was at a high point in its normal range and also coming down and giving a red arrow. This was a great place to exit. Of course it didn’t mean the trend was totally over, but this is how trading plans are built, to give you a good return following a disciplined, systematic approach with clear entry and exit signals. It doesn’t mean catching the ultimate high and ultimate low.

You might have noticed a break of the RSI trendline in May, but the MACD didn’t give a red arrow (close, but no arrow). This is a good example of how using multiple indicators help in avoiding getting out too early.

One last chart. The chart below is daily bar chart of the S&P 500 Index (SPX). I’ve scrunched the data together so you can see all the date since 1997. You will see that when the MACD is at an extremely low level, below -30, and the RSI is also below 30, a large rally usually ensues.

As of this writing (July 11, 2008) we have only the 7th time that we’ve had both the MACD and RSI at these levels. I’ve circled these points on the chart above. I think that points A, C, and D are easy to see that the snap back rally was extreme. At point B, you got a rally as well, but not as extreme as some of the others. At E, you had a double bottom before moving up a little more slowly. Of course F was this January and we did get a good rally but that didn’t begin until mid-March. When this market rallies, it could be a big one, even if only temporarily. You’ll notice the big rallies that you had in the bear market from 2000 to 2003. These rallies just brought the market back up to resistance where the rally ended and in the case of points B, C and D, you ended up going to even lower lows.

Also, you never know when the turnaround will occur. The MACD could still move lower and not be at record low levels (remember, the RSI has a fixed range, but the MACD doesn’t). The bottoms are also not as easy as it looks on the chart above, several of these points actually made double bottoms or had extreme volatility while moving off of the lows. But it’s important to keep this in mind as you look at the chart because it wouldn’t be fun to be caught on the wrong side of a short squeeze.

Conclusion
I’ve gone over a few ways to trade with the RSI. As I’ve said before, I don’t trade with the RSI, I use the Stochastic instead. I do however use the RSI to confirm divergence that I might see on the MACD. If you decide to use the RSI, or if you already do use it, make sure you have rules established to help identify entry and exit points and be consistent in how you use the indicator. You don’t want to start using a lot of indicators in your trading, you need to avoid paralysis by over-analysis. That said, it’s still nice to know about other indicators out there and how to use them properly.

-Mark Jackman
Stock Investor Personal Coach

The Relative Strength Index part II: Divergence

Last week we went over the basics of the Relative Strength Index indicator. It’s important that you have read and understood the contents of that article before reading this article because I will not be explaining anything that was covered in that article. To read that article, please click here.

The RSI is an oscillator with a fixed lower and upper limit. It travels in a range between zero and one-hundred. This means that the RSI has a fixed range, it will never go below 0 and it will never go above 100. Just because the RSI hits an extreme high or low, doesn’t mean that the trend of the stock is going to change, this is a very important aspect of oscillators to always remember. Oscillators by their nature, will often indicate over-bought and over-sold conditions long before a trend is ready to turn. Let’s look at an example of this.

The daily chart below of Foster Wheeler Inc. (FWLT) shows the RSI indicator at 90.54, a pretty high reading, the highest in this set. Yet, the stock just keeps going higher (the reading for the RSI can be found in the Data Window, I drew an arrow on the chart pointing to the RSI reading).

On the day that the RSI reached its peak, the stock closed at $47.95. A few days later, the stock was trading at a higher price. In fact, the stock would work its way up to the $65 level before experiencing a correction of any size. If you sold just because the RSI was at an extremely high level, you would have missed out on over $15 worth of profit.

So what good is the RSI? For one thing, the RSI can give you a lot of information about the underlying strength of a trend. A trend can continue even though the force behind the trend is weakening, but it would be most helpful to be able to spot signs of weakness, so we could at least prepare for a possible reversal.

If you go back and look at that chart of FWLT above, you might spot one sign of weakness that appeared before the big July pullback. Can you see it? If you said ‘Divergence’ then give yourself a pat on the back! Let’s look at that same chart again, but in a different light.

From May to July, FWLT keeps moving higher in price. But these new highs are not being confirmed by the RSI. See how the RSI starts to make a series of lower highs and lower lows. It’s essentially in a downward channel even though the stock is in an upward channel. This is an indication that some big money players are starting to distribute shares and the trend is running out of steam. Please note however, that this divergence lasted for quite some time. You don’t sell or more importantly, sell short just because divergence is present. You need another indicator or signal to confirm that the momentum really is turning. A simple breaking of a trend line, or the stock going to 3 Red Arrow could be your sell signal.

You might have noticed another area of divergence began to form on the right side of the chart. If so, pat yourself on the back again! Let’s go a little forward in time and focus on this area because divergence is one of the most powerful uses of the RSI indicator.

You can see the earlier area of divergence on the left side of the chart, but now you can see the next area of divergence on the right side of the chart. The stock is making a series of higher highs, but the RSI isn’t only failing to make highs to confirm the price action, it’s also failing to get back above 75. This is not a good sign, and you can see the sell off that occurred.

I’ve talked about divergence before (to read an article on divergence with the MACD, click here). I even mentioned last week that I don’t trade with the RSI indicator, but I do use it to confirm divergence that I might spot in the MACD indicator or Stochastic (usually it’s the MACD, as the Stochastic doesn’t always show divergence as well as the MACD does). Let’s take a look at an example of this.

I’ve been worried about steel stocks for a while now. I started to spot quite a bit of divergence on several of the leaders in this space. The first chart shows a daily chart of Mechel Steel Group (MTL), note the very strong divergence as the stock makes a series of 3 higher tops (there’s that number again, 3, hmmm, is that important? Believe it or not, a lot has been written about the number 3 and trading), meanwhile, the MACD and the RSI make a series of lower highs.

This stock finally began to weaken in price, long after our indicators warned of of the underlying weakness that was creeping into the trend.

The next chart of U.S. Steel (X) shows the divergence as well.

The divergence, although not stretched over as long a time period as the one on MTL, is still well pronounced on X. And boy did this stock get spanked last week! When you start to see divergence in several charts of companies in the same industry, pay attention. This is a serious warning sign. This divergence doesn’t mean the stock is going to start a downward trend. It might, but it could also signal the beginning of a long consolidation period. We saw earlier on FWLT, how the divergence led to short term down trends, but the long term uptrend in the stock remained intact.

I’m starting to see some divergence in many of the ag/fertilizer stocks that have been so hot for so long. Below is a chart of Potash of Saskatchewan (POT). Can you spot the divergence?

And here is a chart of CF Industries (CF).

As of this writing (July 3, 2008), these stocks have pulled back to trend lines that are providing support. If the support holds, then the divergence might not be anything to worry about, although it might signal a beginning of a long consolidation period for the stocks. However, if those support levels don’t hold, then the divergence present between price and indicators were definitely warning signs.

Divergence at bottoms
Divergence can also be a very bullish sign. When a stock makes a lower low, but the RSI doesn’t make a lower low, instead it makes a higher low, it can be an indication that the bears are losing control and beginning to weaken. It can be very exhausting after all, chasing bulls away. This type of divergence is often called “Bullish Divergence”, for obvious reasons. The chart below is a very good example of this.

Above is a daily chart of Oceaneering International (OII). You can see a picture perfect double bottom formation in February and March. Double bottoms are better when they are confirmed by divergence in indicators such as the MACD and the RSI as is the case in the chart above.

The next chart of Apple Inc. (AAPL) is a bonus one because we see a bearish divergence form, then a big drop, then a bullish divergence began to appear before the stock made one heck of a recovery.

The bearish divergence was a warning sign that the stock was getting a little too toppy. After the rather large and lightning quick drop, AAPL began to form a very bullish area of divergence. The bulls were definitely trying to make a comeback, and they did.

Conclusion
Divergence is something you’ve seen write about before and you’ll see me write about again. Divergence between price and indicators is one of the most powerful uses of the indicators. The divergence often comes before a break of a trend or the stock going 3 red arrow. It alerts you to a possible change in trend. Don’t neglect the weekly charts, either. If you see divergence on weekly charts, pay attention, it could be serious. Bearish divergence on the weekly charts was everywhere coming into June of this year, and you all know what a bad month it turned out to be for the bulls.

Don’t forget to always look for divergence when you are doing your analysis. Remember though, divergence isn’t always fool proof. You will often see divergence appear, but as a stock continues to push higher (or lower if in a down trend), the indicators will eventually make a new high as well. But when you have another bearish sign, such as high volume selling or a break of trend line or support line, then your price is starting to come into alignment with the indicators and you have to ask yourself if it’s worth it to stay in the trade any longer.

Happy trading!

-Mark Jackman
Stock Investor Personal Coach

Relative Strength Index (RSI)

The Relative Strength Index (RSI) was invented by J.Welles Wilder and introduced by him in the late 1970’s. Since then it has grown to be one of the most widely watched and used momentum oscillators. The RSI indicator measures the strength of up moves with the strength in down moves to give an indication as to the strength or weakness of a stock.

Don’t confuse the RSI with other forms of ‘relative strength’. For example, many traders like to compare a stocks strength relative to its sector or the market. The RSI does not measure this; instead, it only measures a stock relative to itself.

Stock Investor includes the RSI as one of its optional indicators. J. Welles Wilder recommended using a 14-period RSI and that is the default used in Stock Investor. However, many traders will change the time period depending on their style of trading.

The RSI is usually plotted as a single line that oscillates between 0 and 100. Thus, it’s a momentum oscillator much like the Stochastic, but it’s less sensitive than the Stochastic indicator.

The formula for the RSI is relatively simple and can be be found in the ‘Help’ tool of the Stock Investor software. But to save you time from having to search the help tool I have copied it below.

It’s important to note that in the original formula for the RSI, J. Welles Wilder used an average of up closes divided by an average of down closes, putting equal weight on each up close and down close within the range being measured (which is 14 days in the formula above). However, Stock Investor uses a ’smoothed average’ of up closes and down closes, meaning that more emphasis is placed on today and yesterday’s close than on days 13 and 14 ago. It’s like an exponential measurement. Whether you are using the classic RSI formula or this new smoothed version doesn’t matter, as long as you have a set of rules that you’ve tested and you follow your rules consistently.

Let’s take a look at an example of the RSI. The chart below shows a chart of Freeport McMoran Copper and Gold (FCX). The RSI indicator is at the bottom.

The red line is the RSI while the blue line is just a 14 day moving average of the RSI (note: many other charting softwares do not include this moving average, it’s your choice whether or not you want to use it).

You’ll also notice the blue horizontal lines set at 70 and 30. Generally, when the RSI indicator goes above the top blue line (70) the stock is considered to be ‘overbought’. When the RSI indicator goes below the bottom blue line (30), the stock is considered to be ‘oversold’.

I’ve circled various areas of interest on the chart above. I’ve used black circles to point out areas where the RSI was indicating that the stock was overbought, and sure enough, the stock moved down at these points. However, each pull-back in price was different in its magnitude. Only the second overbought indication in July led to a significant pullback. Remember, always go with the indicator when it’s confirming the trend, and FCX was in an upward trend, so overbought conditions didn’t signal a trend reversal, just a pullback. While you might not have sold when the indicator went above 70, you definitely want to think twice about buying when the RSI is above 70.

I’ve also used purple circles to point out areas where the RSI went to the 30 level, but not below it. It’s common in bull markets and strong upward trends for the RSI to find support at the blue line or above, even on large pullbacks (we’ll also talk about this later). Both times, these extremely low levels signaled a good time to buy the stock, as they were confirming an entry that went with the longer term trend.

The Basic Signal
The most popular signals used by traders who use the RSI is to sell when the RSI enters the overbought area and buy when the stock enters the oversold area. Meaning, you sell when the RSI gets above 70 and you buy when the RSI gets below 30. On the chart of FCX above that would have worked somewhat. The problem is that the first time that the RSI hit 70 the stock was trading around $72 a share. The RSI never went to 30 until 4 months later. In between that time FCX went from $72 to $100 a share. This is a problem typical of Oscillators (such as the Stochastic), they tend to give sell signals way too early in a trend. This is why you need to use one or two other indicators such as the MACD, Moving Average or a simple trendline for confirmation.

You will also see traders who use different numbers to represent overbought and oversold levels, while Stock Investor defaults to 30/70, many traders use 25/75 or 20/80. Some traders will change the setting depending on the type of market they are in. For example, in a bull market, they will raise the oversold level all the way up to 40 or 45 since most stocks never get down to the 30 level in a bull market (just like our example of FCX above), at the same time, they’ll raising the overbought level up to 80. In a bear market they may lower the overbought level all the way down to 60 or 65 and lower the oversold area down to 20. If you think about it, it makes sense since counter-trend moves don’t have the same force as the moves that are with the trend.

Again, it doesn’t really matter what settings you are using, you just want to use the same settings and be consistent. Don’t keep changing settings to suit what you think or want to happen. The Walk-Thru Tool is a great way to back test your settings to see which settings work best for you. For our purposes, I’m just going to use the default settings in Stock Investor.

Over and Back Again
While a cross into overbought and oversold areas can be a basic buy and sell signal, some traders will use different signals. For example, a trader might not sell when the RSI goes above 70, instead, the trader might sell when, after being above 70, it suddenly drops back below 70. On the buy side, rather than buying when the RSI goes below 30, a trader might instead buy when the RSI, after being below 30, suddenly moves back above 30. The chart below of U.S. Steel (X) shows a few examples of these entries and exits.

I’ve circled where the RSI went above 70 then turned back below 70 as sell signals. I have also circled where the RSI went below 30 then went back above 30 as a buy signal. The main problem with this is you kept getting sell signals as the stock kept going higher. All those sell signals didn’t do much good because there were not buy signals until near the very end of the chart. Obviously, there needs to be some better buy signals.

Crossing 50
Another signal might be given when the RSI line crosses the center line, which is set at 50. In another words, buy when the RSI crosses above 50 and sell (or sell short) when the RSI crosses below 50. This crossing of 50 might also be a point where you add to you existing position. For example, if you had bought 200 shares when the RSI was below 30, you could buy 200 more shares when it finally moves above 50, adding to your position size.

Let’s revisit that chart for X. I’ve kept the same buy and sell signals that were on the chart above, but this time I added green circles to show where the RSI hit 50 from the upside and bounced off of it. You’ll see that these tended to give you entries that corresponded to the earlier sell signals. In other words, buy when the RSI is at 50, sell when it crosses above, then below 70. However, during a period of consolidation, the entries and exits (red circles) based on the 50 line would have whipsawed you around. Too bad no indicator is perfect.

You can see how, when the stock is trending, the RSI found support at the 50 area. During the period of consolidation in June and July, the RSI danced around 50 giving a lot of bad signals. This is why traders use at least 2 indicators as well as support and resistance. There was another smaller area of consolidation in late August and early September.

The RSI will often trade in a range, just like a stock might. So buy signals could be generated by the tendency of the RSI to reverse at a certain level. Let’s look at an example of this by looking at a daily chart of Transocean Inc. (RIG), you’ll see that throughout an upward trend and consolidation, the RSI seems to find support at about the 43 level. I’ve used green circles to point out these bounces and where the price was at the time. I also used red circles to show when the RSI entered overbought territory. You’ll notice that the RSI seemed to have given some pretty good signals on this stock during this period..

The fact that an oscillator or another indicator can have a level of support or resistance is something many traders don’t consider. The red line that I put in at about t