A story in cricketing folklore tells us how Mrs. Park, the wife of Dr Roy Park, missed the entire international career of her husband due to a freak incident. Dr Park also played football as well as cricket professionally, besides being a medical practitioner and served in the 1st world war in the rank of a captain. As Park took guard and the bowler ran in, Mrs. Park’s knitting fell down, and by the time she looked up after retrieving the knitting, the ball had burst through the defences of Dr Park, and he was already on his way back to the pavilion.
Fortunately, the technical analysis-based signals that are used for trading, mature at a pace that provide traders enough time to deliberate. However, the leading indicators like volume or oscillators, for eg.: RSI or ROC, give out signal when there is high trading activity, which makes risk management a much more onerous deal when compared with the profits that are to be reaped. The lagging indicators like the one based on moving averages, like MACD for example, largely serve confirm a trend in play, that shaves off a good deal from the potential profit. And yet, most traders prefer the latter, as the leading indicators are more in-the-face, requiring you to be more hands on, whereas the lagging indicators give the traders enough time to get his/her eye in. Before discussing the key issues with such lagging indicators, let us take MACD as an example, and understand and how a trading set up based on the same work.
What is MACD, a moving average-based indicator
MACD is the short form of Moving Average Convergence Divergence. As the name indicates, the trading set up consists of two elements, namely, how to form signals, and how to visualise those signals. The first part is achieved by constructing two indicators namely MACD and a signal, both out of moving averages. MACD is calculated by subtracting the 26-period exponential moving average, from the 12-period exponential moving average. The second indicator is called Signal, which is the nine-period exponential average. An additional indicator, which helps more on the visualisation part is the MACD histogram, which charts the distance between the MACD and its signal line. Now, convergences and divergences of these two as well zero-line cross overs are used to set up buy or sell signals. For those who are new to this concept, here are a few basic trading set ups using MACD.
Common MACD signals
- MACD indicator crosses zero line from below. Signal : Buy.
- MACD indicator crosses zero line from above. Signal : Sell.
- MACD indicator crosses Signal line from below. Signal : Buy.
- MACD indicator crosses Signal line from above. Signal : Sell.
- Low height of histogram. Signal : No new entry.
Shortcomings of MACD
Like any lagging indicator, MACD mostly serves to confirm visually a trend that is in play already. In other words, if a sell signal is indicated by MACD, then the down move of the price may have already been in motion for a while, and unless the remaining fall is sizeable enough, the set up will not yield enough profits. Often such set ups see reversals no sooner than a signal is spotted, and the trader gets the feeling that MACD is not a reliable indicator. But the short time frame between the signal and the reversal is inherent to the nature of the MACD set up and not a failure as such. Once that is acknowledged then the trading becomes easier. So, one could narrow down the profit objectives and set up for more frequent entries as a standard rule, and go for the giant kill, with larger capital commitment or a larger profit objective, only when the MACD indications are corroborated by other TA signals. Another case in point is deciding when not place bets on the basis of MACD signals. For example, signal line crossovers may not work well, when the histogram’s size is small, especially during strong trending periods.
I read this recently from a photography site slrlounge: …”as the famous photographer Ansel Adams quote goes, “there’s nothing worse than a sharp image of a fuzzy concept”, meaning, do not focus on equipment so much that you forget about what really matters. Always remember to put your vision and creativity first, and let the tools follow.” There is no better message to a TA based trader who is on a never-ending search for the perfect trading signal.
