Let's take a trip off the beaten path. We'll administer some necessary medicine to a revered technical indicator – the moving average convergence divergence (MACD). Enough articles have been written about the MACD to depopulate half the world's rain forests, but little has been said about the downsides of using this very popular tool. In short, the MACD doesn't work as well as some say it does. It's a glorified moving average, and it's weak at forecasting price direction. In this article we'll cover the controversial perspective of those who spurn the use of this prevalent indicator and what can be used in its place.
The MACD's Seduction
When applied over a long time frame, the signals generated by a given moving average will often seem very random, but a moving average can be a seductive indicator. An exponential moving average is just advanced enough to entice the delight of the technically-minded, but is not so arcane as to perplex the rest of us.
And although anyone could program charting software to reprint the physical separation between any two moving lines, so far, only the MACD holds that claim. This is an attribute that fascinates many traders, while the MACD histogram provides an added air of sophistication.
The true allure of the MACD, however, is that it requires interpretation, in particular with regard to convergence or divergence from upper-screen price action. According to critics of the MACD, this alone has guaranteed its perpetual placement in the pantheon of trading studies – once an idea can be interpreted, it can be elevated to mystical status.
The Good Side of the MACD
Supporters of the MACD argue that there have been countless times when the venerable work horse presaged a profitable move. They would also argue that the MACD is a tool that can be used to quickly gauge the short-term direction of an asset's momentum, without the need for the skills of a professional trader. Readings above 0 indicate that the short-term moving average is accelerating faster than the longer-term moving average, which most traders would view as a sign that the short-term upward momentum is increasing. The opposite is true when the MACD values are below 0. Having an outlook on future momentum, as predicted by the MACD, allows traders to have greater confidence about when they enter a given trade because the underlying momentum is working in their favor.
The Ugly Side of the MACD
However, it is possible that the MACD's success is a result of chance – after all, even a stopped clock is correct 730 times each year. When used as an entry signal to the lush pip-filled world lurking just beyond the hard right edge of our computer screen, the MACD fails time and again – just what we should expect from any mathematically averaged smoothing of past price action. If only we could trade in reverse!
Those inclined to count how many pips can fit on the head of a pin might wish to tweak their MACD in an attempt to make it even more predictive. This is a bit like feeding a variety of performance enhancing drugs to a snail and watching to see whether its meandering trail will bend just a little more to our liking. But would it help us to know where the snail is going next? No, we won't have a clue, and the snail probably won't either.
The MACD uses 26 periods as its farthest backward-looking value. On a 15-minute chart, 26 periods total six hours and 30 minutes. Fifteen minutes goes by pretty fast. There are 96 such periods in a 24 hour day – 480 in a five-day trading week. Therefore, in the grand scheme of things, a single period of 15 minutes is really just noise.
Let's say it's 8:00 a.m. New York time and Bob is watching the 15-minute chart. What is the MACD doing? Still paying attention to what happened back at 1:30 a.m., when New York traders were sawing logs. Nevertheless Bob is sitting there trying to get pips based on where he thinks the market is going in the next 15 or 30 minutes. He wants pips right now. What does he care about where the price was 6.5 hours ago? His favorite pair may have traded above the daily pivot during the Asian session, taken a bounce off strong-long term resistance on the London open and dropped like a rock right into the New York session.
Bob is trying to divine what the Big Boys are likely to do in the next 15 to 30 minutes, which means he needs to understand what they were thinking 15 or 30 minutes ago, not in the middle of last night!
In the end, the performance of moving averages and indicators based on moving averages will always be, well, average. So let's move on.
The Tools of the Trade
What can we use to tell where price is going next? The answer is: nothing. There is nothing in existence that can tell us where price is going next. But there are a few simple tools that can tell us where price is likely to go next – perhaps as often as 80% of the time.
These tools include:
These tools are not sophisticated and require no divinity degree to interpret. In fact, they are not subject to interpretation. Let's take a closer look. Using a demo account remove all the indicators except for support and resistance (trend) lines, pivots and candlesticks.
Here is a short list of what you won't need if you follow this way of investing:
The Candlestick Will Light Your Path
First and foremost, learn to recognize candlestick action. Learn all you can about the hammer, the star – the tower of strength. They are even better when they appear at pivot points or trend lines (for added epiphany think of trend lines as tilted pivots). Learn to recognize that price is a fickle thing that can change its mind faster than Hollywood actors change relationships. The price moves like the people who move it.
When candlestick reversals occur at places where fear and greed occurred before (tilted support or resistance = trendlines), or at anticipated price levels (horizontal support or resistance = pivot points), we have an extraordinarily high probability trade.
Price zigs. A hammer at key support! Price zags. An evening star following a double top at key resistance! And where's the MACD? It's still meandering through the charts like a picturesque mountain stream.
The Bottom Line
In the time it takes a MACD devotee to get out his or her compass and protractor and divine where price is heading next, you could already be in and out of a profitable trade or two. It may go against the accepted norm, but if you give it a try you may just find yourself on a brighter path to profit.