Thursday, May 24, 2012

Forex Trading - Refining Macd Trading Strategies

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.

Moving average convergence divergence MACD is used very commonly in technical analysis for trading. MACD is a lagging indicator and that means that any signals by the crossover of MACD and its signal line are generated with some lag in time. The signals are generated after a confirmation of the move in a particular direction this comes with a time lag. When the trend is weaker, this lagging would tend to cause more false signals.

Why more false signals during weak trends or when the market is ranging or running sideways?:

1) Entry signal: By the time the entry signal is generated, the price may be reaching the reversal point because during the time lag the trend becomes further weaker and market is on the verge of reversal.
2) Exit Signals: By the time the reversal crossover takes place and signals that we should close our position to take profit, the price already reverses so much that the realized profits levels are much less than the realization levels if would have closed the trade sooner.

Though the most important factor in trading are the skills, knowledge and trading discipline but there are always possibilities of improving our indicators also. The improvement can be either by the change in the logic by adding new conditions or by experimenting with different period settings. What we wish to always achieve is to have lesser and lesser percentage of false signals. Albin, Gunter and Kain came up with some refinements in the original MACD for reducing the percentage of false signals which may otherwise be generated. The first refined version is known as MACD R1 and the second is MACD R2 as the subsequent one.

Let's check what MACD-R1 and MACD-R2 are. Our trading platform most probably will not have these refined versions but considering the logics of these, we may think about improving our MACD trading strategies.

MACD-R1:

a) One more condition was added and that was to wait for three periods (days on daily chart) after the MACD line crosses the signal line upwards or downwards before we take a position. 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 then we forget the first crossover and wait for another 3 periods to ensure this reversal.

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 says that don't be greedy and come out of a trade with certain pre-decided percent of profits. These suggested profit taking percentages were 3% or 5%. So MACD R1 says that 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 we should close the trade.

MACD-R1 - weaknesses:

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:

To overcome the above mentioned issue of still higher number of false signals by MACD R1 an additional condition was added in terms of further refinement. The new refined version is known as MACD-R2.

Let's think why MACD-R1 still offers possibilities of reducing the false signals:

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 and what did we miss to avoid it:

This can happen because we waited for the confirmation but ignored another warning signal i.e. what did not happen 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.

What additional changes/conditions are there in MACD-R2:

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 maintains between MACD and MACD signal line even after waiting for 3 periods and then only we enter the market. If the difference between MACD line and the signal line goes lesser than the pre-decided level then we do not enter the market.

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 should not take trade position. We decide this difference percentage based on the experience that a difference less than this may indicate a possible reversal.

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