MAILBAG QUESTION:

"I'm new to using (technical) indicators like PSAR and MACD but still am losing. First, Parabolic SAR - they say that if it goes down you should sell but if it goes up buy. With MACD - if MACD is lower than the signal you sell and vice versa. What's wrong with what I'm doing?"

MY INITIAL RESPONSE:

Using your query for our general OIN trader audience, I need to first define the two indicators you are referring to. Anyone is welcome to skip past these definitions and jump to my specific answer about 'best practices' in using technical indicators.

1.) PARABOLIC Indicator

The indicator you are talking about ("PSAR") is most often referred to as the Parabolic, based on Welles Wilder’s Parabolic Time/Price Strategy. This indicator is based on the relationship between a market’s price and time. It is used to determine when to Stop And Reverse (SAR) a position utilizing time/price-based stops. The way Wilder intended that his indicator be used was that once a Parabolic SAR was reached, the current position was exited and a new position in the opposite direction was taken. It's useful to know that in commodities futures, which was Wilder's main trading arena, there were a number of trading systems or a style of trading (such as with moving average methods) where one was ALWAYS long or short.

The parabolic study is best used in trending markets and is based on always having a position in the market. The indicator may also be used to determine stop points and estimating when you would reverse a position and take a trade in the opposite direction. The indicator derives its name from the fact that when charted, the pattern resembles a parabola or French curve.

2.) MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)

The well known Moving Average Convergence-Divergence indicator, most commonly known simply as the MACD, is a type of indicator that measures market momentum, as well as when trend momentum is slowing and/or reversing, as well as suggesting when a stock, stock index, a Forex item, etc. is in an overbought or oversold condition. Others of this type technical indicator is the Stochastics model and the Relative Strength Index (RSI) and one I often use.

The MACD indicator is calculated by taking the difference between two exponentially smoothed moving averages of closing prices of 12 and 26-day or 12 and 26-week duration; usually these are the only values used; Gerald Appel, the market technician who formulated the MACD indicator, did also suggest that a slightly different set of values be used as a sell signal only. In my opinion, only a purist who relies heavily on this indicator need be concerned about using a variation for this purpose.

The MACD line is the difference between the longer average (26 periods) and the shorter average (12). A moving average of 9 periods then is calculated of this differential (the result of the subtraction), which is called the signal line and results in a faster moving MACD line. The exponential smoothing technique weights the most recent prices changes more heavily and is therefore quicker to track the latest price changes.

The signal line will be slower because it is a simple moving average of the last 9 values of the differential and is not weighted. There is usually a third line plotted, which is a histogram (vertical bars) used to show the difference above and below a midpoint line of the difference between the MACD line and the signal line; this line is included in the 'standard' MACD study to better see the points where there is an upside (the bars go above the midpoint) or downside (bars go below the center or zero line) crossover.

I sometimes dispense with the histogram because it 'clutters' up the chart when the size of the chart window is small. The zero line can be seen anyway. An example of the MACD from my (Essential Technical Analysis) book is shown below:

A reason to include the histogram as part of the MACD indicator is that those bars may present a clearer picture of when the difference of the two moving averages is at the widest and narrowest points. Sometimes it is otherwise difficult to see these details given how much is shown on the MACD indicator, which often occupies a small section below a price chart.

Most often the MACD indicator is used with WEEKLY charts and this is how Appel, the originator, tended to use it. The historical weekly chart example below, also from my book, also indicates the line above which Amazon (AMZN) in this case was considered to be overbought and the line below which the stock was considered to be oversold. Again when the solid MACD line crosses below the 'signal' line, it's a sell/short indication and when the solid MACD line crosses above the signal line, this pattern indicates adopting bullish strategies.

'BEST PRACTICES' USING TECHNICAL INDICATORS

What is wrong in my opinion and in my own experience is that using technical indicators like you describe in an automatic or 'mechanical' way per what is strictly said about what the indicator attempts to portray can be, as you say, a losing proposition. I suggest using technical indicators as tools only and not as a 'system' of trading in a rules-based way. I use indicators like MACD as an input, alert or input only, in conjunction with CHART patterns; e.g., buying on a breakout above a down trendline, selling on a break below an up trendline.

You can get my book or another general book on technical analysis and learn more about the art of technical analysis. If you want a rules-based system then you probably need something like TradeStation software that allows you to test 'what if' scenarios. For example, in back testing in prior years of Forex data, what happens if I go long when the MACD crosses above or below the signal line by going long/buying calls or going short/buying puts respectively. You can then test results of doing this or in modifying this strategy and in using risk managements exit points, etc.

I suggest you use these technical 'tools' as tools only, as advice and not to use them mechanically; e.g., a MACD crossover 'makes' your trading decision for you so to speak. Unfortunately, it can take some time to learn how to achieve profitable trading using a technical approach. Or any approach. I used to use these tools looking to buy or sell according to when the indicator suggested it was time to do so. However, if profitable trading was as easy as using such a trading 'system', all traders would be making money and of course it's not that easy and doesn't happen.

SUBSEQUENT FOLLOW UP QUESTION:

"thank you for your time and advice. I'm sorry to ask this but what is technical and mechanical? when to use or not use? Please give me and concrete example of a graft that shows variation when or not to sell or buy. Thanks."

MY SECOND RESPONSE:

I'll pick out a couple of stock or stock index charts and show how well you might make out if you just took positions using the indicators only based on the way they are theoretically or ideally supposed to 'work'.

PARABOLIC STUDY

The following daily chart of the S&P 500 (SPX) Index is of a period when SPX has mostly had a strong up or down trend. The results of using the parabolic indicator in a strongly TRENDING market is mostly positive. Especially so if the downside reversal points, where you might otherwise take on bearish/short or put positions, are merely used as stop/exit points.

Even in a strongly trending market, chart pattern analysis such as by use of trendlines and trend channel construction, moving average studies, overbought/oversold indicators (e.g., a 13-day RSI), as well as the parabolic study could together be used to paint a 'picture' of how the trend is unfolding; and to keep you in the dominant trend on an intermediate-term basis. Such a use of multiple chart and technical inputs is often if not mostly preferable to using one technical indicator to determine your trading decisions.

PARABOLIC STUDY in NON-TRENDING (Sideways) PERIODS

MACD INDICATOR USE:

Use caution in merely buying/shorting MACD 'crossovers'!


GOOD TRADING SUCCESS!