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Markets rarely move up or down smoothly. Several pullbacks may occur in price advances and rallies in declines, but not all pullbacks are created equal. In this case, not every move of the solid line toward the dotted line constitutes a valid profit alert. False signals occur mainly because there are too few bars prior to the alert and/or too much space between the solid line and the dotted line during the pullbacks or rallies. Most of those false signals can be filtered by using two simple rules: line for at least 14 price bars prior to the completion of the profit alert pattern. (See sidebar “The bar count.”) Count the day that the alert pattern completes itself as zero and then count back 14 days. If the solid line is above the dotted line on the 14th bar, then a potentially valid alert is in place. Fewer than 10 to 12 bars is not sufficient and usually produces a false profit alert signal.

In a downmove, the solid line must be below its dotted line for 14 price bars or more prior to the completion of the profit alert pattern. Again, fewer than 10 to 12 bars usually produces a false profit alert signal.

A pullback or rally that penetrates the dotted line negates the alert. When that happens, the new profit alert would have Rule 1: In an upmove, the solid line must be above its dotted to complete its pattern at least 14 bars beyond the penetration. MOVING AVERAGE CONVERGENCE/DIVERGENCE (MACD) AND MACD HISTOGRAM

The moving average convergence/divergence(MACD) is an advanced indicator, developed by Gerald Appel, using two different-length exponential moving averages (EMAs) of the closing prices of the underlying security. EMAs are used because unlike simple moving averages, they give greater significance to more recent prices and are more sensitive to recent price changes.

The graph of the indicator contains two lines (sidebar Figure 1). The first line is calculated by subtracting a 26-day EMA of the closing prices from the 12-day EMA of the closing prices, and this difference, plotted as a solid line, is known as the MACD line. The second line, known as the signal line, is constructed by calculating a nine-day EMA of the MACD line, and is plotted as a dashed line. Sidebar Figure 2 shows how the two EMAs of underlying closing prices move relative to the underlying.

A buy signal occurs when the MACD line crosses above the signal line, and the sell signal is the MACD line dropping below the signal line.

The MACD histogram, a variation of the MACD, is constructed by plotting the difference between the MACD line and the signal line as a series of vertical bars. The vertical difference above and below the zero line represents the difference between the MACD and its signal line (sidebar Figure 3). The bars will be above the zero line if the MACD line is above the signal line, and the bars will be below the zero line when the lines have switched places. A value of zero in the histogram corresponds to the intersection of the two lines.

The slope of the MACD histogram is determined by measuring the slope of a line connecting two neighboring bars.

Changes in slope of the MACD histogram can be used to signal entry and exit points when trading the underlying market. When the slope changes from positive to negative, long positions are closed and short positions are established.

Conversely, when the slope changes from negative to positive, shorts are covered and longs are established.

SIDEBAR FIGURE 1: MACD FOR ABBOTT LABS. The two lines that make up the MACD are shown above. The solid line is the result of subtracting the 26-day EMA from the 12-day EMA, and is called the fast MACD line. The dashed line is the nine-day EMA of the MACD line and is called the slow signal line.

SIDEBAR FIGURE 2: ABBOTT LABS. Here, we see the 12-day moving average responding faster to price movement than the 26-day moving average. The difference of these two lines results in the solid MACD line.

SIDEBAR FIGURE 3: COMPARISON OF MACD AND MACD HISTOGRAM. This comparison shows the correlation between the two indicators. The amount of separation between the two lines determines the size of the bars. Which line is above the other determines which side of the zero line the bars will be on: above when the signal line is above the MACD line, and below when the two lines are reversed.