MACD (Moving Average Convergence and Divergence) is very commonly used technical analysis indicator. Like any technical analysis indicator, the time lag before a signal is generated becomes an issue with MACD also. Here we will talk about some refined strategies to use MACD to make our trading decisions.
The meaning of the acronym MACD, or Moving Average Convergence and Divergence, indicates an intrinsic problem in Forex trading: it is a moving average, and hence the data it offers will by definition always be historical. Therefore, any radical changes shortly before you use these crossover trading signals as a basis for Forex buy or sell decisions could have a considerable negative impact on your result, particular where trends are weak or the market is ranging. What can be done to avoid this?
When the trend is slowing down or is already fairly slow, the main problems you will be facing using MACD relate to your entry position and your profit taking position thus:
1. Entry Signal: Because the data is historical with a time lag before presentation, the price may have reached the reversal point already before the entry signal is generated. That may be because that during the time delay with a weak trend, the trend weakens further and the market is about to reverse. You therefore enter at an inflated price.
2. Exit: When MACD indicates the crossover with the signal line when you should exit and sell the price may already have reversed to an extent that any profits you realize are significantly lower that they could have been had you been aware of the reversal in real time, rather than delayed time. If problem 1 coincides with problem 2 then you could conceivably lose on the deal and will certainly make a significantly lower profit than expected from the analysis.
So how can you get over these problems, and improve the accuracy of using MACD for an indication of when to enter or take profit? Forex trading analysts, Albin, Gunter and Kain proposed ignoring short-term MACD signals by waiting three days after a crossover has been indicated, and then acting if no further crossover has taken place during those three days. They called this refinement MACD R1.
If another crossover took place, they suggested you wait a further three days (or periods) before taking a position. They also suggested that in order to avoid losing profit by exiting too late after the reversal had taken place you should determine the profit-taking levels in advance. So rather than taking the chance of making a small, or even no profit, due to the lag of the MACD indicator, you should close the trade at a predetermined gain – say 3% or 5% over the entry. Also close the position if crossover occurs prior to the predetermined % target.
Although this might seem sensible, it has weaknesses: There will still be a certain number of false signals since you will never be able to overcome the lag built into historical data, and also, if you close at 3% or even 5% and the trend becomes strong and the profit increases to even 10%, then you will lose out when there was no need to do so.
What then? Does it still make sense to go with R1 or is there some other possibility to improve the accuracy of MACD R1? In fact, there is, and Albin, Gunter and Kain suggested a further revision, named MACD R2. This was intended to overcome the remaining false signals to as low a level as possible.
MACD -R2 Revision
One serious problem with R1 in Forex trading was that between the initial signal and that after three periods (or days), you took a position to buy or sell. However, it is possible for the market to suddenly reverse then, and for another crossover to take place, resulting in you losing money in your Forex trading. Why should this happen?
Simple: after you waiting 3 periods after the original crossover, and a second reversal crossover did not take place, you took a position, but the MACD and signal line may have come very close together without crossing over. A reversal was indicated, but you couldn’t see it and so because the data was historical, the lag meant you had taken a position very close to or even after the second crossover and made a wrong decision by assuming the original crossover trend would continue.
Here’s how MACD R2 deals with this possibility:
R2 adds a predetermined condition prior to you taking a position – there must be a pre-determined difference between the signal line and MACD after the three periods. This should then make sure that there is no imminent crossover that can ruin your trade.
Example of MACD R2
So to put all of this into chronological order, let’s take a Forex trading hypothetical situation where you set a figure of 1.5% as the minimum difference between signal line and the MACD after three periods and that in this case a period is a day.
A: Day 1 – MACD and signal line cross over.
B: Day 4 – You have waited 3 days and no more crossovers have occurred.
C: Check the price – assume that to be 120.00
D: Check MACD – assume it to be 6 (i.e. 12 Day EMA-26 day EMA = 6)
E: Check the signal line – that is 4
F: Calculate the difference and compare to your minimum difference figure: 1.5%
Formula is 100*(MACD -Signal line after 3 periods)/price = (6-4)*100/120 = 1.67%
This is greater than your predetermined 1.5% so you can go ahead with a position. Had the sum been less than 1.5% you would have neglected the signal.
Note on MACD: The MACD is derived from the difference between two moving averages: those of a shorter period and of a longer period. Hence the 12-day and 26-day moving averages used above.
If the term MACD (26,12,9) is used, then:
The MACD for a specific point = EMA for 12 periods – EMA for 26 periods. Periods can be typically days. The 9 refers to taking the EMA of the MACD for the previous 9 periods.
The MACD signal line = the EMA of the MACD line.