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Saturday, May 28, 2011

MACD


MACD is a technical indicator that was developed by Gerald Appel to be traded in financial markets. Although I am not a great lover of trading that is based on indicators, however, this and RSI indicators are my favorite ones. I like putting them on my charts and using them in my own way. Indicators are far from being perfect, so you will need to incorporate other indicators and technical tools to trade financial markets successfully. Standard macd consists of three ema’s (exponential moving averages), 12 day ema and 26 day ema and a signal line of 9 day ema. 

How can these parameters be traded?

Crossovers

Faster ema crossing slower ema

As you may have noticed the most important averages in the indicator are 9 day ema (faster moving average) and 26 day ema (slower moving average). A sell signal is generated when a faster moving average crosses the slower moving average from above and a buy signal is generated when a faster moving average crosses the slower moving average from below. 

I do not trust this method, for it gives a lot of false signals and it can only be applied profitable when a market moves smoothly and does not go sideways. 

Crossing the centre line

When macd moves crosses the centre line from below we have a bullish crossover which would mean that you should go long in a given security and when the indicator crosses the centre line from above we have a bearish crossover which would mean that you should go short in a given security. Depending on which time frame you look and at which period of time you might see a lot of crossovers. If you look at 1 minute -1 hour charts you will see a lot of those as there are lots of daily market fluctuations that cause the indicator go below the waterline and then again back above the waterline. 

Divergences

That’s probably one of the best ways to use macd indicator. Of course, you have to remember that divergences work best when a market is in a range, not when it is trending. If you do not know what a divergence is I might remind you quickly. It is an imbalance between price and indicator. It means that price moves one way and an indicator moves in opposite direction. Let’s assume that a market is going down (as you may see in the chart of eur/gbp below). When a new lower low is made in price, it is not made in indicator. Indicator shows a higher low. It is a divergence. And we can interpret it that price is about to turn up sooner rather than later. 

How I trade these divergences

Just because I see a divergence on 4 hour chart does not mean that I will immediately jump on a trade. I will firstly wait for a reversal pattern. It means that if the price was going down, it should not register lower low but should rally upwards and then after retracing to test previous bottom it has to fail to break it (look at the same example in eur/gbp). Then price come back to its most recent high. It would be good if it tested the level again, retraced and only then broke the resistance (ideal situation). It is very important to look around to see if there is any news coming that might cause a reversal (breakouts very often happen after important news releases). 

So, look for these things in trading the indicator:

  1. Price goes lower
  2. macd goes higher
  3. Price rallies upwards
  4. When it comes back it fails to make a lower low
  5. It comes back to resistance and breaks it.


Contrarian method of trading the tool (The trend way)


All the indicators work for some time, none of the indicators work all the time. Some indicators work under particular market conditions and other indicators work under completely market conditions. Now, moving average convergence divergence is the indicator that is best used in swings that form in a range together with appropriate support and resistance levels. When the price approaches former resistance you wait for divergence and get ready to sell, when it approaches support you wait for divergence to buy. 


Unfortunately, these rules should be put aside while trading in a well defined trend when prices rise or fall for a prolonged period of time. The indicator will give you a truckload of false signals and you will lose more than you make trading the indicator the traditional way. Look at the daily chart of usd/jpy to see that. It indicates 4 specific cases where you had clear price and indicator divergence (meaning prices should fall) and yet prices continued rising, because market is in a strong bullish trend. 

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So, what do you do when you have divergences in a trend? You trade against them. You wait for a rally against a major trend (correction or a counter trend rally) and when the rally is over you jump back into a trend. How? I wait for bullish candles on various time frames if we have a bearish counter trend rally in a major bullish trend. Look at the chart and you will see that you could have bought after each counter trend move when bullish candles appeared on a daily chart. 

Alternatively, you can wait for 123 patterns on smaller time frames (1 or 4 hour charts) and go long when point 2 is taken out. Fundamental news releases can also be of great advantage for you to jump back into the wagon and riding with the wind. In fact, when some tendency is prevalent in the market you’d better forget all of your indicators and trade with the trend. That is my best advice for you. When the move stalls and ranges develop pick out your indicators and trade ranges by selling at the top of the range (resistance) and buying at the bottom of the range (support). 



 

Read my posts:


Trading moving average convergence divergence


Moving average


Disclaimer
Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.