A different approach using the same MACD indicator
I know what you are thinking, another article about the MACD, zero line, crossing signals, blah blah, blah… no, trust me, it’s not that.
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If you’ve been part of the trading community for some time, you’ve probably encountered countless articles and guides discussing the MACD indicator and its various applications. It’s true; the MACD has become one of the most used indicators in technical analysis, offering traders valuable insights about the market. However, what I want to share with you in this two-part article series goes beyond the conventional MACD trading strategies.
At the beginning, we will cover the basics of MACD to ensure that we all have a common understanding before moving on. We will go over the standard techniques that traders have used for many years and have been effective in various situations. These techniques are the building blocks for many trading strategies and are what most traders consider when using MACD in their trading.
But let me be clear, the intent here is not to use the same old MACD concepts you’ve come across countless times. Instead, my goal is to give you a fresh perspective, and an innovative approach.
While the MACD has earned its place in the trader’s toolbox, it’s the way we use this tool that distinguishes the successful traders from the rest.
Let’s start with the most basic question…
What is MACD?
The MACD, or Moving Average Convergence Divergence, is a widely used technical indicator in trading. Created by Gerald Appel in the late 1970s, it is designed to help traders identify potential trend changes and momentum shifts in an asset’s price.
At its core, the MACD is a trend-following momentum indicator based on the differences between two Exponential Moving Averages (EMAs) of an asset’s price. The MACD is represented as a histogram and a signal line on a price chart, providing traders with insights into market dynamics.
Here’s how the MACD is calculated (with its default values):
Calculate the Short-term EMA: Typically, this is a 12-period EMA of the asset’s closing prices.
Calculate the Long-term EMA: This is a 26-period EMA of the same closing prices.
Compute the MACD Line: Subtract the Long-term EMA from the Short-term EMA. This results in the MACD line, which is also known as the “fast line.”
Signal Line: Calculate a 9-period EMA of the MACD line, which creates the signal line.
MACD Histogram: The difference between the MACD line and the signal line is represented as a histogram, providing visual cues about the strength of the trend.
Easy ahhh? Any trading software has the MACD Indicator implemented by default. Also, there are a lot of programming libraries that implement or give you the tools to implement the indicator.
Before continuing with the second question, if you enjoy reading my articles, please hit the follow button — Diego Degese
Let’s continue with the second most asked question…
What Are The Standard Ways to Use MACD for Trading?
It’s essential to cover the traditional ways traders use the MACD to trade the market. These “standard” methods have been tried and tested over the years and form the foundation upon which many traders build their strategies.
MACD Crossovers: One of the most common ways to use the MACD is by monitoring for crossovers between the MACD line and the signal line.
Bullish Crossover: When the MACD line crosses above the signal line, it generates a bullish signal, indicating a potential uptrend in the asset’s price. This is seen as a buying opportunity.
Bearish Crossover: On the other way, when the MACD line crosses below the signal line, it generates a bearish signal, suggesting a potential downtrend in the asset’s price. Traders might consider this a signal to sell or short the asset.
While MACD crossovers can be powerful signals, they are not without their drawbacks. Whipsaws, where the MACD generates false signals, can be common during choppy or sideways markets.
Zero Line Cross: Another standard approach is to watch for the MACD line crossing above or below the zero line.
Above Zero Line: When the MACD line moves from negative to positive territory by crossing above the zero line, it indicates a potential shift from a bearish to a bullish trend. This is considered a buying signal.
Below Zero Line: On the other way, when the MACD line crosses from positive to negative territory by moving below the zero line, it signals a shift from a bullish to a bearish trend. This is seen as a selling signal.
Similar to MACD crossovers, zero-line crosses are susceptible to false signals, especially in volatile markets.
Divergence: MACD divergence occurs when the MACD histogram creates higher highs or lower lows that are not reflected in the price chart. This can be a powerful signal indicating a potential trend reversal.
Bullish Divergence: This occurs when the MACD histogram forms higher lows while the price chart shows lower lows. It suggests that the downward momentum is weakening, potentially signaling an upcoming bullish trend reversal.
Bearish Divergence: On the other way, bearish divergence occurs when the MACD histogram forms lower highs while the price chart shows higher highs. This suggests that the upward momentum is weakening, potentially signaling a bearish trend reversal.
Divergence can be a valuable tool for traders but requires a thorough analysis to avoid false signals.
Histogram Bars: Traders also analyze the shape and size of the MACD histogram bars. Larger bars indicate stronger momentum while decreasing bars suggest weakening momentum. Some traders look for specific patterns, such as “MACD saucers,” where the histogram gradually transitions from negative to positive or vice versa.
Monitoring the histogram bars in conjunction with other indicators can provide additional confirmation for trading decisions.
Well, enough with the known information, let’s jump to the approach I gave to MACD.
Before continuing with my approach, if you enjoy reading my articles, please hit the follow button — Diego Degese
Explaining my Approach
As you may know, my approach involves using the MACD indicator, but in its percentage version (PPO or Percentage Price Oscillator). To make this approach more understandable, let’s break it down into four crucial components:
Minimum Distance to Buy: Think of this as your “buying threshold.” It represents the minimum value you want to see in the histogram before you consider buying an asset. In simpler terms, it’s like saying, “I won’t buy unless this is over this value.”
Trend to Buy: This component helps you decide when to buy based on recent changes in the histogram. It’s like looking at recent history to see if the histogram has been going up, or down. Depending on the trend, you may decide to make a purchase or wait.
Maximum Distance to Sell: Just as you have a minimum for buying, you also have a maximum threshold for selling. This means you won’t sell your asset if the histogram is over a certain level.
Trend to Sell: Similar to the Trend to Buy, this helps you decide when to sell based on recent changes in the histogram. It’s about gauging whether the histogram is going up, or down before you make your selling decision.
With all the parameters defined, we’ll look at a certain number of past values when considering these factors. Imagine this like looking back in time to see how the histogram has behaved before making your move. The number of past values you examine is an essential part of your strategy.
Finding the Best Values for Success
Here’s where the magic happens. To make your approach highly effective, you want to find the perfect combination of values for those four components — Minimum Distance to Buy, Trend to Buy, Maximum Distance to Sell, and Trend to Sell. These values are like your secret recipe for success.
But you don’t just guess these values randomly. Instead, you use a systematic method to discover them. You look back at historical data and test various combinations of these values to see which ones give you the best results. It’s like being a detective, analyzing past financial trends to uncover the winning formula.
And what are those “best results” you’re seeking? We will look for the best Expected Value which is represented by the following formula:
Expected Value = (Win Rate * Positive P&L) + (1 -Win Rate) * Negative P&L
In this case, the Expected Value penalizes the negative P&L and rewards the Positive P&L.
We will stop here and leave something for Part 2.
Conclusion
As we ended Part 1 of my approach to trading with the MACD indicator, I want to thank you for your time and interest in this topic. We’ve explained the strategy core, and its components, and introduced the concept of Expected Value — a critical element used to optimize our strategy.
Here’s the exciting part, in Part 2, we’re going to continue with the practical implementation of this approach. I’ll publish the source code, which will put these concepts into action. You’ll have a chance to see how these principles are applied and test the strategy with your own data and parameters.
So, if you’re hungry for more knowledge, eager to enhance your trading strategy, or simply curious to see how my approach works, I encourage you to stay tuned for Part 2. I promise you that will be an exciting continuation of this article that will give you all the details.
See you soon…
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