Indicators, What are they?
Indicators are computerised technical studies. It means that their values are derived from the price using mathematical formulas and plotting its results along with price or below it in a separate graph.
Chart 1- S&P500 Daily with Bollinger Bands, Stochastics and MACD
The concept behind the idea of these computations is to try to discover hidden patterns or facts about the current situation of the price. The moving average, for instance, computes the average of the price over a period. Its value can be considered the fair price for the period in question. The Stochastics oscillator, on the other hand, plots oscillatory graphs that try to position the current price in relation to the maximum and minimum of the assessed period. This can be viewed as a dynamic overbought oversold assessment based on the short-term market cycle.
What do we Need Indicators for?
In every trading strategy, there are two parameters which make sense improve: Percent winners and Reward-to-Risk ratio. These are, in fact, the only two parameters that matter long term.
Price action tells the trader a fast and lag-less way to enter the market. Usually, speed comes together with a reduction in the odds, especially so if the trader is inexperienced. Thus, we need to find the right indicators that help us improve the odds of succeeding without harming too much the reward factor.
The main factors to improve the consistency of the results are:
- Knowing the direction trend
- Assessing the turning points
Assessing the current Market Direction Using The MACD
The MACD is an easy and fast visual indication of the current price direction.
The MACD is a derivation of the Moving Average study. The MACD line is the result of the subtraction of two exponential moving averages. The standard MACD uses a 12 period EMA and a 26-period EMA to create the MACD Line.
The Signal Line is a 9-period EMA of the MACD Line. That means the Signal line has a small lag with respect to the MACD Line. The crossing of the MACD Line and the Signal Line are considered price turning points.
For traders, the rationale is that by tracking the difference of two moving averages we are comparing the traders’ sentiment on the recent action against the overall sentiment of a longer period. Changes in it would come before the main price movement.
Reduction of the Lag
The fact that the MACD is similar to a derivative of the moving average – The subtraction is the key math operation in a derivative- makes the MACD Crossing signals to lead the EMA crossover signals. This property allows to go beyond the standard use of the MACD and experiment with longer periods.
Avoiding False Signals
People using it to get direct signals to trade are obsessed with getting them fast, by reducing the SMA cycles even more. The downside of it is the MACD deliver a lot of false signals when the price stalls and creates sideways movements. If we just use the MACD to determine the current price direction we can be more creative and use MACD with longer parameters. I’ve performed a lot of backtests using the MACD and my experience tells me that the MACD works better in high volatile markets with longer SMA periods.
Chart 3 – Two Different MACD Settings
On chart 3 we can observe the comparison between the standard MACD setting and a 20-40 one. We can see that the later (at the bottom) shows a slight lag on the crossovers which does not degrade too much the signal but the whipsaws in the sideways movements ( left) and with the volatility growth (right) get minimised.
You should experiment to find the right parameters for the market, but it is worth the effort. In the end, you’ll get an indicator that will help you determine the current bias of the price and avoid taking trades against it.
- The MACD will be used to determine the current price movement
- If the MACD Line moves above the Signal Line an upward movement has started.
- If the MACD Line moves below the Signal line a downward movement begins.
Using the Stochastics to Determine Overbought and Oversold Conditions
The Stochastics indicator is a technical Study devised by Dr George Lane in 1950 to determine in which part of the price range was the price.
The formula subtracts the current price to the Lowest price of the period (of the last n values of the price action, where n is the period). And divides the result by the total range, defined by the High minus the Low. The result is multiplied by 100 and is called %K line. Stochastics values range from zero to 100.
To make this value less volatile there is a second line, the %D Line, which is a short-period average (usually 3 periods) of the %K Line.
Chart 4 – EURUSD 4H with MACD and Stochastics
As we see the Stochastics is an oscillator, and, since this is a direct price subtraction, is a leading indicator. It works very well when the price range, as is the case of the left section of Chart 4, but gives false signals against the trend as seen in the right part of the chart. So, when the price is trending we should give credit only of the Stochastics turns that go with the trend.
The combination of these two indicators will help to confirm price action and avoid taking trades at wrong places.
The MACD will help to know the current price direction and also detect when the impulse is stalling.
The Stochastics help to assess overbought and oversold conditions and not taking long signals when overbought or short ones during oversold areas.