Thursday, 2 March 2017
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Chaikins Money Flow

We have looked at Risk (Click on 'Risky Business' article below). That included an assessment of a share price's volatility. Within that I mentioned Chaikin's volatility. 

Marc Chaikin was a US stockbroker – he's still alive. He started his career in 1965. He did a lot of early work developing computer based proprietary formulas to help US fund managers (one of the first to do so – computers haven’t been around that long).

Chaikin is quoted as saying “I have always believed that earnings drive stock prices….I have a theory on Wall Street: bad things happen to companies that are over-valued, good things happen to companies that are fairly valued or cheap”.

This is something I’ve also noted, if the big themes are right (right industry at the right time) then good things happen, like positive earnings surprises, good profit result reactions, takeovers, share buy-backs, dividend increases. And the managers of these cyclically well placed companies are heralded as heroes, when many of them, again, just happen to be in the right industry at the right point in the cycle. With his roots in options trading Chaikin developed a number of stock market indicators and a business around them which was bought by Instinet which then turned into Thomson Reuters. He also had a regular slot on CNBC.

But that aside Chaikin is best known for developing the following proprietary computer algorithms. By the way, you do not need to calculate these, just understand them, so do not get put off by the formulas, all these indicators are contained in almost every commercial charting package without any effort on your part:

ADL – The Accumulation/Distribution line.

This is the basic principle of Chaikin indicators. For Accumulation read “buying”. For Distribution read “Selling”. What this ADL indicator is based on is the idea that if a share price closes in the top half of the daily trading range it is Accumulation which indicates that on balance there is buying support, and the higher the volume the more relevant the support.

The flip side is Distribution (selling) and this is evidenced by a share price closing in the bottom half of its daily range and the more volume there is the more relevant the selling. So we are looking at where in the daily range a stock closes and how much trade there is.

This ADL (Accumulation Distribution Line) is given by this simple formula:

  • "AD" = the Accumulation/Distribution cumulative total running line.
  • "cum" is an abbreviation meaning "calculate a cumulative total running line".
  • "C" is the daily closing price.
  • "H" is the daily high price.
  • "L" is the daily low price.
  • "V" is the daily total volume.

So if the number is negative there is selling and if positive there is buying and the more volume there is the more negative or positive it is.

Here is a chart of BHP with the ADL (Accumulation/Distribution Line).

You can see that the scale here is in billions of dollars. This makes it hard to compare one stock to another so Chaikin then developed a better indicator.

The Chaikin Oscillator

As you can tell from the title this is an ‘oscillator’ which means the formula includes a bit of maths which forces the indicator to ‘oscillate’ around zero. I'll probably lose you here but...the Chaikin Oscillator is a bit like MACD, it compares the exponential moving average of the Accumulation/Distribution Line over 3 days and 10 days and when the 3 day (or week) EMA (Exponential Moving Average) crosses down through the 10 day (or week) EMA it means the stock is changing trend for the worse and creates a sell signal. When the 3 day (or week) EMA of the ADL (lost you yet?) crosses up through the 10 day (or week) it indicates a positive change of trend and triggers a buy signal.

So like MACD, a cross from above to below zero is a sell signal and a cross from below to above zero is a buy signal. This chart is using weekly data…so is more for investors than traders. You can see the recent sell signals on BHP, the first since the end of July last year.

Now we move onto another indicator - Chaikin Money Flow (CMF).

This is another oscillator that moves above and below zero and is based on the same principle as the Accumulation/Distribution line which suggests that repeated closes in the top half of the daily trading range represents buying pressure and is bullish and if its closing in the bottom half of the daily trading range it is bearish. At the risk of losing you again, it measures ‘Money Flow Volume’ – to understand that think of it as measuring how much money is flowing into or out of a stock.

It is usually measured over 20 or 21 days or weeks. A number above zero indicates an uptrend and below zero indicates a downtrend.

The formula (you can skip this bit) first measures where a share price closes in the range. This is simple enough and is called the CLV (Close Location Value). The formula is:

Work that out and it’s just telling you whether a stock is going up or down determined by whether its closing in the top or bottom half of the daily range. A negative number is bottom half and a positive number is top half.

Now Chaikin combines this with volume to produce the CMF (Chaikin Money Flow) – this now incorporates the volume over the last 20 days with the CLV (where it closes in the daily range):

This is Chaikin’s Money Flow on a chart of BHP on a weekly basis – as I say…see this as an indicator of whether money is flowing into or out of a stock – a positive number means its flowing in. So you can see the buying pressure in BHP has been fading:

More commonly Chaikin indicators are used on a daily basis rather than a weekly basis (his roots were in the options market after all - shorter term). So this is BHP and Chaikin’s Money Flow on a daily basis over 6 months:

What does it mean? Here are the Chaikin Money Flow signals:

  • Go long if there is a breakout above resistance supported by Chaikin Money Flow above zero.
  • Go short if there is a breakout below support confirmed by negative Chaikin Money Flow.
  • Go long if you see ‘Divergence’ between CMF and the share price. So if the share price is falling and CMF is rising.
  • Go short if you see ‘Divergence’ between CMF and the share price. So if the share price is rising and CMF is falling.

A weakness of the CMF indicator is that it does not account for gaps in a share price, so unusually large moves on one day create big movements in MVF on the day they happen and then on the day they drop out (21 days later). The guy who runs Incredible Charts has developed his own take on Money Flow called Twiggs Money Flow which adjusts for this. He does that by using true range instead of highs minus lows and by using exponential smoothing instead of a simple moving average in the formula. You can Google all that.

Suffice it to say Chaikin’s Money Flow is just another indicator. There are so many. And as with MACD and RSI, both of which we use in the newsletter, CMF is yet another piece of the jigsaw rather than the whole cake. Combined with other factors it tells a story but on its own it’s a bit limited.

But let’s not let reality get in the way of a good story. Chaikin has taken his work one commercial step further with the currently available (for a price) Chaikin Power Gauge.

The Chaikin Power Gauge Rating

This is a rather more commercial offering sold as a subscription on a US website.

Not satisfied with the basic indicators there is another indicator which is being sold by a company called Chaikin Analytics co-founded by Marc Chaikin and Sandy Chaikin. It is called the Chaikin Power Gauge Rating which rather nicely presents stocks on a gauge where red suggests that a stock trend is bearish, yellow is a neutral rating, and green is bullish.

To get this rating they combine 20 fundamental and technical indicators to 5,000 stocks a day. They say the gauge was “developed for self-directed investors in order to provide them with access to information generally available only to institutional investors”. At least that’s the marketing.

The 20 factors they use are organized into four categories: financial metrics, earnings performance, price-volume activity, and ‘expert opinions’. One of the factors in the rating is Chaikin Money Flow (CMF). The gauge they say has been back-tested on 10 years of data and they say it provides positive results in terms of being able to predict stock performance for individual companies over a range of three to six months. It’s a daily rather than weekly based indicator. The 20 factors are updated daily.

Looks nice. Presents simply and confidently. Perfect.

A bit of cynicism:

But on the subject of indicators, to be a bit cynical, when you consider that all technical indicators, from the terribly sophisticated to the most simple, are based on 5 simple data points every day – open, close, high, low and volume – you begin to realise that the best indicator, and the purest, is not the third derivative of a stochastic oscillator at all, it is the share price.

Hate to say it, but the best technical analysts are sometimes the utterly naive. Show a share price chart to a 10 year old and ask them if the share price is going up or down and they’ll go “Duh! Its going up” – or “Duh! Its going down”.

To complicate that observation with indicators that are all derived from the same basic data can often be little more than creating something out of nothing and in this industry, creating something that can be bottled and sold. Add good graphics, simple but confident conclusions and a lot of clever marketing to a simple single indicator and you have a business. 

Speaking of might have heard of W.D.Gann whose technical indicators are also on every commercial piece of charting software and whose theories still occupy a chapter in every course on technical analysis. 

Gann's son, John Gann was a stockbroker in New York. Alexander Elder, in his book Trading for a Living, said: "Various opportunists sell Gann courses and Gann Software. They claim that Gann was one of the best traders who ever lived, that he left a $50 million estate, and so on. I interviewed W.D. Gann's son, an analyst for a Boston bank. He told me that his famous father could not support his family by trading but earned his living by writing and selling instructional courses. When W.D. Gann died in the 1950s, his estate, including his house, was valued at slightly over $100,000. The "legend" of W.D. Gann, the giant of trading, is perpetuated by those who sell courses and other paraphernalia to gullible customers."

So don’t take anything one indicator too seriously. The obvious share price trend tells the main story.

The real value of a formula based indicator that assess the data every day, is not to tell you whether to buy or sell, but to attract your attention when something is happening. This ability to drag your attention towards a stock has value and if that’s what indicators do (flash at you) then all this computer based analysis is quite useful.

But no one indicator is gospel, from the fundamental (intrinsic value is often sold as the Messiah) to the technical (Chaikin’s Money Flow), there is not Holy Grail. An indicator is simply what it is, an indicator that you may need to make a decision, not an instruction to buy or sell, not on its own anyway.

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