No indicator can give all correct signals all the time and hence continuous refinement in the strategies to use an indicator is a must to avoid as many false signals as possible. Getting a few signals which are good is always better than getting a lot of signals of poor quality.
MACD (Moving average convergence and divergence) is one of the most popular technical analysis indicators and is quite commonly used by
Forex traders. The crossover trading signals given by MACD are when the MACD line crosses the signal line upwards or downwards. These crossover signals are lagging in nature. That means that the crossover takes place after having a confirmation that yes the prices were peaked or bottomed down for the time being and a move in the opposite direction is on the way. This confirmation comes with a time lag. Though during strong trends this time lag does not impact the trading decisions much but weak trends may be another story and may cause generation of a good amount of false signals.
Weak trending markets and false trading signals:
1) Entry signal: Crossover signal comes with a time lag. By the time the entry signal is generated, the price may be heading for a reversal as during the this time the trend might have become further weaker and market starts heading for a reversal.
2) Profit taking or exit signals: There is again a time lag and by the time the reversal crossover takes place which signals that we should close our position to take profit, the price already reverses so much that actual realized profits are much lower than the realization which could have taken place if we would have closed the trade a bit sooner.
What we wish to always achieve from a technical analysis indicator is less percentage of false signals. Though it depends on the skills, knowledge and trading discipline of the trader but then there is always a room of improving the indicator or the strategies of using the indicator. Albin, Gunter and Kain came up with some refinements in the original
MACD for reducing the percentage of false signals. The first refined version is known as MACD R1 and the second subsequent refined version came in the form of MACD R2.
In this article we will see as to what MACD-R1 and MACD-R2 are. Understanding these may have an impact on reviewing and refining our MACD trading strategies.
MACD-R1 (refinement 1):
a) MACD R1 has an additional condition to the basic MACD crossover signal. This conditions asks us to wait for three periods (days on daily chart) after the MACD generates a crossover trading signal by MACD main line crossing over the signal line either upwards (buy signal) or downwards (sell signal). What it means that we do not take a trading position as soon as the crossover takes place but wait for 3 periods for further confirmation of the trade. This wait was to ensure that the signal was not false and an immediate reversal does not take place as soon as we take a position. If during this 3 periods another crossover takes place on opposite side (reversal side) then we ignore and forget the first crossover and wait for another 3 periods for the confirmation for this reversal. The summary is that we wait for 3 periods to be sure.
b) To avoid the exit problem as mentioned in point number 2 above, MACD R1 has the profit taking levels as pre-decided percentages. In a nut and shell it means that ensure some minimum profits than to wait for bigger gains and losing the chance of even those minimum gains. These suggested profit taking percentages were 3% or 5%. To summarize, MACD R1 strategy is to close the trade after 3% or 5% gain after the entry. In case a reversal crossover takes place before this pre-decided target of 3% or 5% then also the position should be closed.
Week points of MACD R1::
1) Even with these additional conditions there still is higher number of false signals.
2) Loss in the profits: Let's assume that it is a strong uptrend and after taking a buy position the prices move up by 8%. And what we did was, we closed the position after 3% or 5% profit and hence the opportunity of making higher gains was lost. basically we may end up in making a big loss in the profit and that goes against the mantra that let your profits run and cut your losses short.
MACD-R2 (refined version 2):
To overcome the above mentioned issue of still higher number of false signals by MACD R1 an additional condition was added as further refinement. This new refined version is named as MACD-R2.
Let's think how we can further reduce the percentage of false signals generated by MACD-R1:
Trade scenario: We wait for 3 periods to have the confirmation of the trend continuation by seeing that no reversal crossover takes place during this waiting period. And after this 3 periods we enter the market. As soon as we enter the market, a reversal takes place and we end up with losses.
Now let's see why the above mentioned scenario is possible while trading and what did we miss so that it could be avoided:
This scenario was possible because though we are waiting for the confirmation but are ignoring another warning signal that what has not happened may happen soon now.
This may happen because though by the end of the 3 periods after the original crossover, another reversal crossover does not take place but the MACD line comes dangerously close to the signal line to indicate a reversal. The difference between the MACD and signal line reduces drastically. We are not keeping track of this development and ignore this reducing difference between MACD line the signal line even though it indicates the possibilities of a reversal crossover.
Additional conditions built into MACD-R2 as strategy:
Now when we know what we missed, we have to add that condition so that we do not lose the track of the reducing difference indicating a reversal.
An additional condition was added apart from the original concepts of MACD-R1 to design MACD R2. This condition is to ensure that we keep a track of the difference between the MACD line and the signal line and do not ignore a warning signal of a possible reversal. This condition ensures that a pre-decided difference is there between MACD and MACD signal line. This difference should be there even after waiting for 3 periods. If the difference between MACD line and the signal line goes below the pre-decided level then we ignore the crossover signal and do not take a trading position.
Suppose we decide that the minimum difference between MACD and signal line should be at least 1.2% at the end of 3 periods. What it means is if the difference between these two lines is less than 1.2% then we ignore the signal generated by MACD crossover 3 periods back and do not enter the market. We decide this difference percentage based on the experience that a difference less than this may indicate a possible reversal.
For the explanation of this third condition please see the following example:
Let's consider that we are talking about daily trading chart which means that 1 period means 1 day.
1) Suppose MACD and MACD signal line crossover takes place on July 1st.
2) We wait for 3 days and see that no further crossover has taken place during this time i.e. till July 4th.
3) We check the price. Let's say it is 150.00
4) We check MACD (12 day EMA - 26 days EMA). let's say it is 5.
5) We check the signal line (previous 9 days EMA of MACD). Let's say it is 3.
6) We use the formula (MACD-Signal line after 3 periods)*100/(price)i.e. (5-3)*100/150 = 1.33%
now as 1.33% difference is bigger than the pre-decided minimum difference i.e. 1.2%. This indicates that we can enter a trade as a reversal crossover may not be taking place soon.
In the case that the difference between MACD and its signal or trigger line was less than this pre-decided level of 1.2% then we would not have taken the position as per the signal generated by MACD crossover 3 periods back.
About MACD: Note: MACD is derived by a difference of exponential moving average of a shorter period and exponential moving average of a longer period. And MACD signal line is the EMA of the MACD line itself. If we are talking about MACD (26, 12, 9) that means
MACD for a particular point = EMA for 12 periods - EMA of 26 periods.
The Signal line is derived by taking the Exponential
Moving Average (EMA) of the MACD line. Here with MACD (26, 12, 9) we are taking the EMA of MACD for pervious 9 periods.
