Combine MACD And Relative Strength To Time Trades

06/15/12 08:29:17 AM

by Mike Carr, CMT

Relative strength is a powerful trading tool, but its signals can be difficult to interpret. Applying
indicators to relative strength can help.

Security: SPY
Position: Sell

Indicators are widely used by traders to time entries and exits. The idea behind this is that the
indicator smoothes the price action and offers more reliable signals than price alone.

Moving average convergence/divergence (MACD) is a popular indicator and could be used as a stand-
alone trading strategy. Many traders also use relative strength (RS), which can highlight stocks that
are outperforming the market. Here, the theory is that outperformance is likely to continue, so
owning the strongest stocks can deliver market-beating performance over time.

RS can be charted like price and trades can be taken when RS is rising, or trades might be taken when
RS is below some arbitrary level such as 80 (which indicates the stock is outperforming 80% of the
other stocks). The disadvantages of these ideas are: if RS is charted, the data is choppy just like it
would be with price, and calculations of numeric RS ranks often requires a subscription service to
monitor the ranks.

Both of those weaknesses can be overcome with an additional RS technique that traders should
consider, the momentum of comparative strength (MoCS) indicator developed by market technician
Christopher Hendrix. MoCS substitutes an RS calculation for price into the traditional MACD formula.
The theory behind MoCS is that a stock's momentum can highlight when prices are changing
directions. A positive value of MoCS would show that momentum is rising and a negative MoCS
should highlight downtrends in price. The formula for MoCS is:

MoCS = (12-period EMA of (Stock/S&P 500)) - (26-period EMA (Stock/S&P 500))

where EMA represents an exponential moving average. Stock represents the closing price of the stock
being evaluated, and the Standard & Poor's 500 represents the close of the S&P 500.

In trading software, each program will require different forms of this equation. In Trade Navigator
software, it would simply be "MACD (Close / Close of SP, 12, 26)," where SP is the value of the S&P
500 exchange traded fund (ETF), SPY, although any index or ETF that tracks an index could be used
here. This formula could be used to chart an indicator like the one shown in Figure 1.
FIGURE 1: SPX, WEEKLY. The S&P 500 is shown with the MoCS indicator, which looks like a MACD
histogram.
Graphic provided by: Trade Navigator.

Figure 1 shows that this approach offers clearly defined signals as the MoCS moves above and below
the zero line. It is also possible to add a moving average to MoCS as a signal line; a nine-period moving
average is used as the default, as it is for the MACD calculation, although all of the variables of MoCS
could be changed. The signal line and indicator approach is shown in Figure 2.

FIGURE 2: SPX, WEEKLY. The MoCS is shown as the green line with a nine-week moving average
added as the black line to provide trading signals.
Graphic provided by: Trade Navigator.

Backtesting shows that this indicator (with the histogram approach) offers a good starting point for
developing a robust trading strategy. Long-only, trading SPY when the MoCS histogram is positive and
moving to cash when it is negative, the profit factor is a healthy 3.21 using data from the beginning of
1991 and weekly signals. A similar profit factor (3.30) is obtained when testing on the more volatile
NASDAQ 100 ETF (QQQ). Profits are lower with the signal line added in testing, but the system is still
tradable. Variations of this strategy (different parameters or time frames) could offer better results.