Technical analysis is as much an art as it is a science. No one parameter, by itself, will allow us to make our buy/sell decisions. However, when all the indicators are used together, they paint a picture that is critical to maximizing our covered call success. One of the most simple and reliable of these parameters is the Moving Average Convergence Divergence, or MACD.
Definition:
MACD is one of the most basic and effective “momentum” indicators that also serves as a trend-following indicator. So let’s call the MACD a trend-following momentum indicator. Momentum is defined as the rate of acceleration of a stock’s price and trend in an upward or downward direction. The MACD is formed by subtracting a longer-term exponential moving average (EMA) from a shorter-term EMA (which are trend following indicators). The resulting plot forms a line that oscillates above and below zero without any upper or lower limits. So what does the MACD tell us? In short, MACD gives us prior notice before two EMAs cross. This notice can be used to discern bullish (buy) and bearish (sell) signals, as described in detail below.
MACD Formula (common example):
The stock’s 26-d EMA is subtracted from its 12-d EMA. The resulting line created by these price points is called the MACD. A 9-d EMA of the MACD itself is also plotted and acts as a “trigger line.” A 9-day EMA is used so we can get a quick reading on the potential changing momentum of an equity’s price. The subtraction of the trigger line from the MACD itself is the basis for the MACD Histogram, an even quicker indicator than the MACD ( to be detailed in next week’s blog). Let’s look at a chart (bottom quarter) which depicts these parameters:
- MACD
The black arrow shows the MACD itself (black line); the red arrow shows the trigger line (red line); and the blue arrow points to the MACD Histogram (light blue bars). Note how the MACD oscillates above and below the zero line, which is also known as the “centerline.”
MACD- Bullish Signals
There are three types of bullish signals that can be detected from the MACD: (1) positive divergence; (2) bullish moving average crossover; and (3) bullish centerline crossover.
1- Positive Divergence- the MACD begins to advance while the security itself remains in a downtrend (Figure below):
Note how the green MACD trend lines are positive (below the green arrow on left), while the actual price of the security is in a downtrend , as evidenced by the downward sloping (negative) red trend lines, which corresponds with a downward sloping 20-d EMA (blue line) . The green arrow also indicates a positive MACD histogram (blue bars are above zero).
2- Bullish moving average crossover (Figure below) - the actual MACD moves above its 9-d EMA (the trigger line).
MACD- Bullish Moving Average Crossover
Note how the red arrows depict the MACD (black line) crossing above the trigger line (red line), with the histogram (light blue bars) turning positive. The price of the stock then skyrockets (long red arrow). Whenever the MACD itself crosses the trigger (9-d EMA) the histogram will be positive (discussed next week).
3- Bullish Centerline Crossover (Figure below) – the MACD moves above the zero line (centerline) and into positive territory. This can be used as a confirmation of the positive divergence and bullish moving average crossover rather than choosing any one of the three.
Bullish Centerline Crossover
As the MACD (black line) moves above the zero line (red arrows), the stock heads north (blue arrows). Using a combination of these bullish signals can produce a more meaningful signal than using just one. I favor the MACD Histogram by itself as it is an earlier indicator of a price change and easily viewed on a chart. The three just described can serve as confirmation when evaluating stocks in more detail.
MACD- Bearish Signals
- Negative Divergence- MACD declines as security moves sideways or up.
- Bearish Moving Average Crossover- MACD declines below its 9-d EMA.
- Bearish Centerline Crossover- MACD moves below zero into negative territory.
Utilizing a combination of the three bearish signals above will provide a more reliable indicator of a negative price change in the equity. Once again, when it comes to MACD I generally view the histogram which I will discuss in next week’s article.
Advantages of MACD (black line):
- It is a reliable indicator that should be used in conjunction with other indicators (moving averages, the stochastic oscillator and volume)
- Incorporates both trend and momentum into one indicator
- Using exponential moving averages eliminates some of the lag found in simple MAs
- Foreshadows moves in the underlying security
In next week’s blog, I will detail the MACD histogram in Part II of our discussion of moving average convergence divergence. For our premium members, the MACD parameter screened and alluded to in your premium reports is the histogram. (The charts and associated information were taken from my upcoming third book.)
Article highlighting The Blue Collar Investor:
I was interviewed a few weeks ago by Shoestring Venture for an article that will be published in the Business Book Authors section of their website. The date of publication will be Monday, September 19th and the article can be accessed at the following link:
http://shoestringventure.com/2011/09/19/take-charge-of-your-financial-future/
This link will not be active until the 19th.
Market tone:
August was a rough month for the economy and the stock market as global issues, zero job growth and consumer concerns about our economy impacted retail sales. Here is a summary of this week’s mixed economic reports:
- Business inventories increased for the 19th consecutive month in July although less than anticipated.
- Retail sales were unchanged in August
- Industrial production rose 0.2% in August, the 4th consecutive monthly gain
- Manufacturing also continued to rise
- Consumer Price Index (CPI) rose 0.4% in August, more than expected mainly due to auto and gas prices. The Fed does not appear to be concerned about inflation
For the week, the S&P 500 rose by 5.4% for a year-to-date return of (-) 1.9% including dividends.
The improvement in the market during the past month is directly related to the declining volatility which is a pattern we see over and over again. Global concerns have rocked the market and now we see a calming sentiment leading to a recovering market, at least short term. Here is a chart of the VIX, the CBOE Volatility Index also known as the investor fear gauge:
The VIX as of 9-16-11
If we were away, let’s say on a cruise in Europe, and didn’t know what the market had been up to, we would expect the following based on this chart:
- April to August: A sideways trending market (yellow area)
- Early August: A market declining exponentially (red arrow)
- Mid-August to mid-September: A recovering market but NOT to the point it had previously been (green arrow)
Now let’s look at a chart of the S&P 500 during this time frame using the same color-coded references:
S&P 500 as of 9-16-11
The inverse relationship of the market behavior and the VIX is once again confirmed. If this pattern continues, I will be taking a more aggressive stance in my covered call writing.
Summary:
IBD: Market in a confirmed uptrend
BCI: Cautiously bullish, laddering strikes but favoring in-the-money strikes.
Thanks to one and all for your participation in our BCI community.
Another study shows that covered call writing beats buy and hold:
http://online.barrons.com/article/SB50001424052702304867804576570813728185244.html?mod=BOL_hpp_highlight_bottom
As with past studies, there are many BCI principles not utilized that would elevate returns significantly more than those of the study. For example, here are a few aspects of the BCI methodology ignored in these studies:
1- Stock selection
2- Strike price selection
3- Use of exit strategies
However, the basic determinations cannot be ignored: The buy-write strategy can elevate returns and reduce risk.
Alan
Alan,
In your system do you give equal weight to MACD and stochastic oscillator or is one more important than the other? Thanks.
Paul
Alan,
on your weekly report a few stocks are listed as “chart less than 1 year”. What is the significance of that note?
Thanks for your help.
Sara
Paul (#2),
When it comes to interpretation of chart technicals there is no right or wrong. It is a matter of what works best for you once you have mastered the mathematics of the indicators and viewed dozens and eventually thousands of charts. For me, the 4 parameters I have set forth in my books and DVDs work best. No one parameter is conclusive. They form a mosaic that leads me to a conclusion. When the chart pattern is bullish with all confirming indicators and a positive market tone I get more aggressive and write out-of-the-money strikes on high beta stocks. When the technicals are mixed and market tone is mixed to negative, I am much more conservative and sell in-the-money strikes on low beta stocks. Bottom line: MACD and the stochastic oscillator are (each) only one of several indicators that form my ultimate decisions.
Alan
Premium Members,
The Weekly Report has been uploaded to the Premium Member website.
Best,
Barry and the BCI Team
To our members:
When viewing the report that Barry recently uploaded to the premium site you will see 70 stocks on our running list. This is a bit more than the 40-60 I allude to in my books and DVDs. However, of these 70, 19 are not eligible for the October contracts due to the upcoming earnings reports. Of the remaining 51, 31 are in “bold” and represent the “best of the best” as of 9-16-11. When you see an extensive list like this it is a product of the fact that we now screen thousands of stocks in our database and the market conditions have recently been bullish.
Alan
Sara (#3),
When you see the note “Chart less than 1 year” it means that the IPO (initial public offering) occured less than 1 year ago. Some investors prefer to trade stocks that have a longer history of trading on the markets and we want to provide that information to our members.
Alan
Premium Members,
A revised report has been uploaded to the Premium Member website. Look for the report dated 09-16-11-REVA. We made slight edit…no impact on the results.
Barry and the BCI Team
What do you think about josb. It has 6 green circles and a scouter of 9? Good chart too.
Lori
Lori (#9),
JOSB is a retail stock that reports monthly same store sales. As a result, it is on Alan’s “Banned List.” Monthly same store sales can have the same impact as an earnings report…so retail stocks are not considered using the BCI methodology.
So…while any given retail stock that reports monthly same store sales may be a great stock, we don’t consider them in the system. There have been retail stocks considered in the past…even on the running list, but those stocks do not report same store sales.
I hope this clears up the question.
Best,
Barry
The link to the Blue Collar Article/Interview is now active:
http://shoestringventure.com/2011/09/19/take-charge-of-your-financial-future/
The BCI team
Thanks Barry. I forgot about that list of banned stocks.
Lori
Do you ever use these banned stocks after the monthly reports come out like you do with earnings reports?
Frank,
Good thought but this usually doesn’t work because the stats are usually released on the 1st Thursday of the month leaving only 2 weeks until expiration. See the list below for this years release dates.
Alan
I have mutual funds in my IRA accounts and writing calls in non-sheltered accounts. It just dawned on me that I should reverse this. Any thoughts on this will be graetly appreciated.
Roseann
Allan,
Do you have a rule for how to decide if a stock is too risky like your Taser example in your first book?
Thank you.
Stuart
Roseann (#15),
This is a question best answered by your tax advisor. I can make some general observations:
1- Passively managed mutual funds have minimal tax consequences.
2- Covered call writing generates a monthly cash flow of (predominantly) short-term capital gains in non-sheltered accounts. I try to keep as many of my cc accounts in sheltered vehicles.
Your tax advsior should guide you in the direction that is best for your specific situation.
Alan
Alan,
Is” Exit Strategies” available on kindle? I didn’t see it on Amazon.com.
Fran
Roseann (#15),
First, keep in mind that your risk tolerance in an IRA account is lower than a non-retirement account. This is because you cannot REPLACE your losses with other funds. CC writing provides a better return than simply parking it in cash or a mutual fund, but choose the stocks carefully.
For non-retirement accounts the advice I give my clients is, “If you insist on earning 1/2% just to keep from paying extra taxes, you miss the entire point of making money.” If you have non-retirement funds you are willing to use for covered calls, by all means do so. keep in mind that the gains will generally be all short term, but if you can make $300 writing covered calls, instead of making $42 leaving the money in the bank, why wouldn’t you. It’s not how much you PAY, it’s how much you KEEP that matters.
My 2 cents worth.
Stuart (#16),
Since the option premium is greatly influenced by implied volatility (market anticipation of the stocks volatility during the option cycle) I will avoid most trades involving more than a 6% , 1-month return for an at-the-money strike. This is a guideline rather than a hard and fast rule.
Alan
Fran (#18),
“Exit Strategies…” is NOT in kindle format. The charts and graphs were not condusive to setting it up that way. My first book is available in kindle format as will be my upcoming third book.
Alan
BCI strategy help ( & real life example) – what are the guidelines on exiting a position (not the option, but the underlying stock)? Used 9/16 Weekly Stock Screener to select PPO. On 9/19 purchased 200 PPO at $67.23 and sold 1 contract @ 65 strike for $560 and 1 contract @ 70 strike for $290. Now it’s 3 days later and stock is at $58.21. 65 contract ask is 1.85 and 70 contract ask is .85. Do I bail out and buy back the contracts and sell at a loss? Or shouldn’t I give up so easily since the market is very volatile and a rebound is likely
Hi Marc,
I have that one also (but more contracts). The market has plummeted a huge amount so far the past two days and is dragging down all stocks and ETFs. The good news is that we are at the beginning of a 5-week cycle and there is a lot of time for recovery. If this were a decline specific to this one corporation I would definitely consider unwinding the entire position and using the cash in a new position with a different equity. Since this is an overall market issue the question is: do I want to stay in equities or turn to cash until the market calms. Only you can make that decision for yourself. I am happy to tell you what I do in scenarios like this one. I watch the option premium and act if the price meets the 20%/10% guidelines (see pages 18-19 of “Exit Strategies…”). If so, I institute an exit strategy and look to “hit a double” early in the cycle or “roll down” later in the cycle. Unwinding is a possibility if the stock is significantly underperforming the market.
The key is to stay calm and make all decisions non-emotional ones based on sound fundamental and technical principles along with common sense.
Expiration Friday is October 21st.
Alan
Premium members:
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
For your convenience, here is the link to login to the premium site:
http://www.thebluecollarinvestor.com/member/login.php
Not a premium member? Check out this link:
http://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team
Alan,
How can we tell which months have 4 or 5 weeks in the option contract?
Thank you.
Lori
Lori,
The monthly option contracts expire on the third Friday of each month. The four week cycles are where the first of the following month is on a Friday. That makes expiration Friday the 15th. If the first of the month is on a Saturday the expiration Friday is the 21st.
So, just look a calendar, mark the third Fridays of the two months, and you will know the number of weeks for that particular option month.