MACD- How to reduce false signals
MACD (Moving Average Convergence Divergence) is one of the most commonly used indicators but like each technical indicator has its own limitations.
MACD is lagging indicator and hence any signal generated by crossover of MACD line and signal line will lag in time i.e. the signal will be generated sometime after the price has topped or bottomed up. This may give false signals when the trend is slow or the market is ranging.
The main problems when the trend is slow or slowing down are as follows:
1) Entry: By the time the entry signal is generated, the price is reaching the reversal.
2) Exit (Taking profit): By the time the crossover takes place for closing the trade, the price already reverses so much that the profits realized are much less than what it should be.
As an effort to overcome these issues Albin, Gunter and Kain came up with some refinements in the original MACD. The first refined MACD is known as MACD R1 and this was further refined to get MACD R2.
Let’s see what MACD-R1 and MACD-R2 are:
MACD-R1:
a) Wait for three periods (days on daily chart) after the crossover to take a position. If during that period another crossover takes place then forget the first crossover and wait for another 3 periods.
b) To avoid the exit problem as mentioned in point number 2 above it pre-decides the profit taking levels. What it means that close the trade after 3% or 5% gain after the entry. In case the crossover happens before this pre-decided target of 3% or 55 then also close the position.
Weaknesses of MACD-R1:
x) Still higher number of false signals
y) Just imagine that the trend is strong and after taking a buy position the prices move up by 9%. And what we have done is closed the position after 3% or 5% profit and lost the opportunity of making a bigger profit. So we had a big loss in the profit.
MACD-R2:
MACD-R2 was suggested to overcome the above mentioned weakness of MACD-R1 i.e still the number of false signals are more even if much better than original MACD.
Why still higher than desired false signals by MACD-R1;
A possible scenario: We waited for 3 periods and as no crossover took place during this 3 periods duration, we took a position. But then what happened was that as soon as we took a position, a reversal in the market took place and another crossover happened and we made a loss. Well the signal proved to be a false signal.
And why did it happen?
It happened because though by the end of the 3 periods after the original crossover, another crossover did not take place but the difference between the MACD and signal line reduced too much. We ignored this reducing difference between MACD and the signal line even though it was indicating that another crossover may take place soon and our position may end up wrong.
How MACD-R2 takes care of this:
MACD-R2 takes care of it by putting one more condition with the original concepts of MACD-R1. The additional condition for taking the position is to ensure a pre-decided difference between MACD and the signal line even after waiting for 3 periods. This difference is to ensure that another crossover which can make our trade a failure is not happening soon.
So suppose we decide that the minimum difference between MACD and signal line should be 1.2% at the end of 3 periods i.e. if the difference is less than that then we will not enter a position. So we see the following 9for this third factor):
Consider that we are talking about daily chart and hence 1 period = 1 day.
1) Assume that MACD and 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 1.33% is bigger than the decided minimum difference of 1.2% so we go ahead and take a position.
In case this difference was less than 1.2% then we would have neglected the signal.
Note: MACD is derived by a difference of a longer period Exponential moving average and a shorter term EMA. And MACD signal line is the EMA of the MACD line itself. If we are talking about MACD(26, 12, 9) that means
MACD = EMA for 12 periods – EMA of 26 periods.
MAVD Signal line = 9 period EMA of MACD line
About the Author
The author is a consultant at ForexAbode.com. ForexAbode.com provides daily and long term trading Forex analysis based on Fundamental, technical and psychological aspects of the market. Also provides trading assistance by way of news, economic calendar, Currency converter, charts and trading tools like pivot points, currency correlation etc. Also good resources for beginners to learn about technical indicators such as MACD, moving averages etc
Simple Forex MACD Trading System
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