Doubling-Up with Indicators

[RichardCox 10]

One of the things that attracts newcomers to technical analysis is the wide variety of indicators that can be used to assess price data in a more objective way. What most people don’t know is that the logic behind many of the most commonly used indicators is relatively similar. This should not be a total surprise because, in some cases, collections of indicators have been created by the same person (J. Welles Wilder would be a primary example).

 

It is, however, possible to make small alterations to these indicators and change the number and type of signals that are received. To take this approach even further, it is possible to plot multiple readings of the same indicator and use the comparative results as a basis for trading decisions. When exiting a trade, market conditions will never be what they were when the trade was opened. At the same time, psychological factors will often cause to hold onto trades too long (usually when markets are working against a trade), or to exit too quickly (once small gains are finally seen).

 

Both of these scenarios have clear drawbacks and can quickly lead to substantial losses. Indicators can help traders avoid some of these situations because these tools arm you with information that describes when a trending move has reached completion and is ready to reverse. For these reasons, it is preferable to wait for technical signals to materialize before pulling the trigger to close a trade, rather than relying on emotional reactions to do the same.

 

Using the MACD to Measure Trends

 

One of the most common indicator tools used by traders is the Moving Average Convergence Divergence (MACD), as it helps to enhance the probabilities in determining the lengths of trending moves. But which parameters should be plotted on the charts? The default settings in trading stations will generally call for the following: The MACD Line subtracts a 12-day EMA from a 26-day EMA. The Signal Line is a 9-day EMA of the MACD Line itself, and acts as a “signal” for trades (identifies potential turning points). Finally, the MACD Histogram is plotted, and shows as either “positive” or “negative.” The Histogram is positive if the MACD rises above the Signal Line. The Histogram is negative if the MACD falls below the Signal Line. These elements can be seen in the charted example.

 

The job of the MACD indicator is to help traders establish trades and then hold those positions until the current move has run its course. This is important because traders will typically spend much more time on their trade entry decisions than they do with their trade exit decisions. While it is a good idea to spend time with your entries, it is ultimately your exits that will determine your level of profit or loss. Tools like the MACD are designed to maximize your strategic decisions and fine tune your exit levels within the larger trend.

 

Understanding the Signals

 

The MACD sends signals to traders in a few different ways. As the name suggests, the indicator focuses on the convergence and divergence seen between the two moving averages. Convergence is found when the moving averages move close together. Divergence is seen when the moving farther apart. The Signal Line is simply an average of the MACD Line.

 

Because of this, the Signal Line will lag behind the MACD Line. When the MACD Line crosses above the signal line, positive momentum is expected and buy positions should be initiated. When the MACD Line crosses below the signal line, negative momentum is expected and sell positions should be initiated. Illustrated examples can be seen in the second chart.

 

In addition to this, buy signals are generated when the MACD Line crosses above the histogram. When the MACD Line crosses back below the histogram, momentum is negative and this is a signal to sell an asset. These signals help traders to know whether or not a specific price move has enough momentum to warrant a new position. As always, multiple signals (such as a Signal Line crossover, combined with a Histogram crossover), add to the validity of any potential positions.

 

Doubling the Indicator for Exits

 

Once you have a firm understanding of how the indicator works, we can change some of the parameters to work off of the traditional way position exits are constructed. In most cases, traders will use the same logic for entering MACD positions as what was seen when the trade idea was initiated (for example, a Signal Line or Histogram crossover). Unfortunately, this will create many scenarios where the trader will exit a position before the entire move is complete. So, while the MACD is helpful in these areas, there are still ways to improve and capture a larger portion of each move.

 

This can be done by adding an additional plotted MACD. The reasoning here is that the faster MACD (which is more sensitive to price changes) can be used to generate signals for position entries (as this helps you spot developing or changing trends). The slower MACD (which is less sensitive to price changes) can then be added to your charts. To do this, you will need to change the parameters when making the addition (as it would make no sense to again use the default settings). The initial MACD would show the difference between the 12-day and 26-day moving averages.

 

For the slower MACD, we can raise this to show the difference between the 19-day and 39-day moving averages. The Signal Line can be kept constant as a 9-day average of the MACD. The signals generated by this additional MACD plot can be used for exiting positions. So, for example, if we are in a long position, and the second MACD plot shows a negative cross of the Signal Line and/or a cross below the Histogram, the position can be closed on the expectation that the initial bull trend is reaching its end. The parameters for second MACD can be entered fairly easily using the “properties” area in your trading station.

 

Once this is done, you will notice both MACD readings serve different ends. The faster MACD is useful in that it is key for allowing us to spot new trends in their early phases. This indicator is less useful for trade exits, however, because it will often lead many traders to exit their positions before most of the trending move has completed. When we add a slower MACD to our charts, fewer signals are generated. In addition to this, the slower MACD will give you an idea of the broader picture. So when counter trend signals are generated in the slower MACD plot (for example, a sell signal in an uptrend or a buy signal in a downtrend) if becomes a better idea to exit the position and capture your profits before they are given back.

 

Conclusion

 

Indicator tools are an excellent way of viewing price action in more objective ways. In many cases, however, these indicators can lead us to exit positions well before the full trend moves unfold, and this can lead to large reductions in profits. But when we double up on our indicators (and extend the time periods for their measurements), we can get a broader picture of when trends are actually coming to an end. For the MACD, its creator (Gerald Appel) actually recommended that traders use multiple plots of the indicator but this is rarely something that most traders today would even consider.

[4EverMaAT 10]

The main challenge with the approach of using multiple indicators is that the trader lacks the basic understand of exactly what the indicator is supposed to indicate (a mathmatical or numerical measurement of [whatever] Even with this knowledge, it is even more difficult to trade because the trader does not have the confidence to enter trades due to the lack of consistency in the indicator's signal. In this case, the trader is using the indicator as a prediction tool, and is unlikely to wrap around any type of money management to control the risk, let alone understand the entry and exit process.

 

Is it a consistent set of entries and exits? Or does it change with each setup? Are all the exceptions known before entering? These are just some of the more important aspects of real trading to consider. Multiple indicators usually add to the confusion of predicting market direction, not remove it.

[sergso 10]

The main challenge with the approach of using multiple indicators is that the trader lacks the basic understand of exactly what the indicator is supposed to indicate (a mathmatical or numerical measurement of [whatever] Even with this knowledge, it is even more difficult to trade because the trader does not have the confidence to enter trades due to the lack of consistency in the indicator's signal. In this case, the trader is using the indicator as a prediction tool, and is unlikely to wrap around any type of money management to control the risk, let alone understand the entry and exit process.

 

Is it a consistent set of entries and exits? Or does it change with each setup? Are all the exceptions known before entering? These are just some of the more important aspects of real trading to consider. Multiple indicators usually add to the confusion of predicting market direction, not remove it.

 

Good points. I agree. I like to add the risk of missing the best trend when using multiple indicators.

[binnie 10]

One of the things that attracts newcomers to technical analysis is the wide variety of indicators that can be used to assess price data in a more objective way. .......

 

Interesting idea Richard. Thanks.

Can you please explain how to get 2 Macd's into same panel. I can drag & drop another type of indicator onto the Macd panel but not a 2nd Macd. I must be doing something very basic.

Cheers:doh: