Uncommon signals from Common Indicators II

Welcome back,

This second article on seeing the same tool, indicator, pattern or event as others, yet processing and proceeding in a different fashion.  Hence the name - uncommon signals from common indicators.  Again this harks back to a life-long approach of mine - look at the same palm tree from a different angle!




More Uncommon Signals from Common Indicators

An inevitable part of most people's journey through the markets involves looking at, and perhaps using, indicators. Indicators can be useful in trading, notwithstanding the fact that they are a derivative of price action. By this I mean that I believe that the prices (Open, High, Low and Close) provide the purest message of where a market wants to go, or does not want to go.

Indicators are derived from a formula that is applied to the same prices to provide another graph or chart that needs to be analysed. Without a true understanding of how an indicator functions given certain price movements, many traders simply buy 'when the green lines crosses the red line' or sell 'when the price closes below the blue line' or something very similar. After a while when the anticipated profits do not materialise many traders move onto the next indicator/s, only to experience the same frustrating result.

The chief currency dealer of the world's largest options trading organisation shared the following wisdom with me when I was conducting a two month in-house training course for them back in the 1990's.

A definition of insanity: Doing the same thing, but expecting a different outcome!

Today most charting packages provide so many different indicators, traders become confused as to which indicator to use, when to use it etc. By truly understanding the various indicators a trader can ascertain which indicator can produce the type of signal that a trader is looking for, given their trading objectives.

In this article I shall share with you some overlooked or even unknown trading signals provided by the MACD.  Other commonly used indicators also have some uncommon signals that could be incorporated into a rule based trading systems approach (RBTSA). I must stress that these uncommon signals are merely ideas for entering the market and, as such, form only a part of a complete RBTSA. Exit strategies, add-on points, profit-take strategies, money management rules and position sizing concepts are also integral parts of a thorough trading plan.

I urge you to read my articles on money management and position-sizing concepts based on an actual trading system. The equity graphs illustrate the tremendous difference they can make to the outcome of applying a set of trading rules to a market.

The final, often overlooked aspect of any set of trading rules is its 'tradeability'. In other words, whether a particular trader's psychological makeup is in line with the performance of a set of trading rules. I am referring here to things such as win/loss ratio, number of losing trades in a row, number of trades that it takes to recover from a drawdown, depth of drawdown and more. The globalisation of trading, especially the foreign exchange (FX) markets which trade on a 24 hour basis around the world, as well as the after-hours electronic trading that is available on virtually all the futures markets around the globe, means that trading opportunities exist at all times of a day and night.

Part of the tradeability concept is whether traders needs to change their lifestyle to accommodate trading a given set of rules. This may be appropriate for one trader,but not another, irrespective of the performance of that trading approach. By 'truly understanding' how an indictor functions and performs, I am referring to one's ability to answer questions such as:

• Is there any dependency between the outcome of trades when using moving averages?
• Can the MACD produce a 'buy' when the market moves up or down or sideways?
• Can the RSI produce a 'sell' signal on an up close?
• The Stochastic Oscillator can only produce a 'buy' signal on an up close?

My real break in actually understanding indicators came early as I started my journey through the markets in the PC era ... pre-computers that is! Part of my learning curve involved the purchase of all the historical daily US Treasury Bond futures data. There was about eight years of data involved as I did this way back in the early 1980's. I then proceeded to construct daily, weekly and month charts of all the four contracts per year as well as to calculate and plot a range of indicators for each chart.

The various indicators that I laboriously and 'lovingly' calculated and then plotted were:

• Multiple moving averages (G Allen)
• MACD (G Appel)
• Directional Movement Index (J. Welles Wilder)
• Parabolic ( J. Welles Wilder)
• Relative Strength Index (J. Welles Wilder)
• Stochastic Oscillator (G Lane)
• % Range (L Williams)

Back in those early days I spent about 6 to 8 hours a day constructing the historical charts, complete with all the indicators listed above. Initially I constructed bar charts, and then moved to plotting candlestick charts about the time my book, Listen to the Market, was published by McGraw-Hill in the early 1990's.

I soon recognised the commonly accepted and known signals used by traders and analysts around the world. As I was drawing the charts by hand and calculating and plotting the indicators by hand I soon began to see other signals. At first I wondered whether I was just 'seeing things' or whether these uncommon signals actually had merit. I then embarked upon some focused research and was able to validate some of the uncommon signals that I had seen on charts of various timeframes and also in different markets.

Let's start by having a look at the MACD as presented by its originator, Gerard Appel way back in the 1970's. The chart below is a weekly candlestick chart of the Dow Jones Industrial Average with a MACD in the bottom section. The MACD consists of two lines and is derived by calculating the difference between two moving averages (the faster or more reactive of the two lines) and a moving average of that line (the slower of the two lines). It is important to bear in mind that the MACD calculations only use the closing price in its calculation.

Weekly DJIA candlestick chart with the MACD below

As the market has essentially gone sideways between those two points, this commonly known and used MACD signal has failed to produce a profit. This would be expected as the MACD is regarded as a trend-following indicator, especially when used in this fashion. The two traditional signals were the cross-overs at A is a sell, followed by a buy at B.

Now, what happens when you view the MACD in another way? Let the slower of the two lines define the direction of the market you wish to trade in.

Same weekly DJIA candlestick chart with the MACD below

If the slower line is higher than it was on the previous period, buys would be in order; if the slower of the two lines is lower than on the previous period, then sells are the order of the day.

The next step is to wait for the faster of the two lines to move up for at least two periods for a sell (whilst the slower line is going down). This gives you a 'heads up' to look to go short. On the other hand, when the slower line is pointing up, wait for the faster line to move down for at least two periods.

This is a heads up signal to look to buy the market. 'Heads up' simply means 'get ready' to take a position. It is like a warning, if you will, that the market is getting ready to reverse direction.

The actual entry price or entry fashion is a separate issue. A chart signal in the direction of the heads up, such as a pivot point, or an open-close reversal, or even a candlestick pattern can be used. Remember that there are five bar chart patterns that can be used and a couple of candlestick patterns that can also be used for the timing of your entry.

Alternatively, you could use the %R indicator of Larry Williams, or even the break of the previous bar's low in the case of a short, or the previous bar's high in the case of a buy. From this example below, you can see that this uncommon signal from the MACD gets you in after a reaction in the market. The slow line simply determines whether you are looking for a heads up for a buy or a sell. The faster line is the one that provides the actual heads up signal.

A - The faster line has moved down for the prerequisite two periods, thereby giving a heads up buy. The following period provides a candlestick buy chart pattern that I discuss at length in my article on Hybrid Fractal Charts. It is known as a 'hammer' pattern. The market then rallied until it provided the same pattern in reverse (5 periods later), known as a 'shooting star'. Potential profit was 180 odd points. This is an example of how the actual chart signal to act may come one or more periods after the heads up.

B - This time the heads up signal was accompanied by a classic L.I.V.E. setup that I presented to the ATAA members in Brisbane about five years ago. Again the market rallied after achieving the entry level for 3 periods. This time the market rallied for about 100 points.

C - This heads up sell warning came at the very top of the next rally. The traditional and common application of the MACD is as a trend-following indicator, nowithstanding the concept of divergence with the MACD histogram. Once you truly dounderstand how an indicator does really work, you will be one step closer to being able to envisage what is possible to achieve by being involved in the markets. The very next period provided a pivot point sell timing tool that saw the market then decline by about 390 points.

D - The slower of the two lines is still heading south and the faster line has moved up for two periods, thereby providing the heads up for a potential shorting opportunity. You would have had to wait for two more periods for a sell chart signal to appear. This time it was a 'reversal' pattern, one of the five bar chart patterns that I mentioned earlier. The entire fall was 601 points over the next eight periods. As this is a monthly chart, that naturally equates eight months of falling prices. How much of that fall you actually capture trading would depend on your entry and exit rules, as well as your discipline to stay with the trade for the entire eight months.

Other factors that any trader needs to consider are entry, stop loss placement and how to manage a trade. In this article, I am merely addressing one small aspect of devising a trading plan. It is up to the individual trader to determine whether an idea fits into their paradigm.

So far we have looked at a chart of the Dow Jones and a chart of the All Ords. Two markets virtually on opposite sides of the world and different time frames, i.e. week and monthly. From my perspective, when I look at any trading idea, it is important to assess whether the idea, or the rule, passes my Universality Test. This simply states that for any trading rule, or set of trading rules (system), to be valid, it must be equally applicable to any market anywhere in the world and on any timeframe. Quite straightforward really. A bit like an universal truth. This ensures that the rule, or trading system, is not curve-fitted to a particular market or even a particular time frame.

With today's inexpensive computers and widely available software any new trader, or even veteran traders, can thoroughly test trading ideas or rules before putting their hard earned cash into the market to find out if an idea works. Trading is the same as getting involved in a new business venture; due diligence must be part of the preparation before diving in. To spend several years researching, constructing and testing rule based trading approaches is really not out of the question. Designing a profitable trading system has many rewards beyond the obvious one.

When one starts the journey through the markets it is not uncommon to focus overly on where is the market going (forecasting), when do I buy and when do I walk away with a big fat profit. There are no shortcuts or easy solutions.

Another hurdle to overcome is that markets move through various phases, trending and non-trending in oversimplified terms. Then you discover that some tools or indicators work well in certain phases of a markets evolution only to provide disappointment when the market embarks on a different phase.

One important aspect to stress at this stage is that this application of the MACD is not designed to catch every single movement. Rather, its role is to provide high probability opportunities that do exist consistently in all markets. Additionally, I am sure you have noticed how these high probability opportunities seem to occur after the market has started a movement in one direction and is followed by the virtually inevitable counter movement, commonly known as a pullback or a correction.

I would also like to highlight the fact that most successful traders have more than one setup in their arsenal of trading tools, rather than simply relying on one. This is a bit like a surgeon having more than one scalpel, a mechanic having more than one spanner or a sailor having more than one set of sails on a yacht. That way it is more likely that a trader will be able to find a trading opportunity no matter what phase a market may choose to be in, or choose to go into. Alternatively, if a trader does have only one setup, then that trader would scout a large number of markets looking for that particular opportunity.

This is not unlike a share trader scanning their entire database of stocks looking to find a likely candidate to buy or sell. Similarly they may examine various time frames in their search for that particular setup. This is where my concept of Hybrid Fractal Charts (HFC) comes into its own. I have written a series of three articles on this topic.

The next market that we shall have a look at for uncommon signals on the MACD is the most actively traded currency pair in the world - the Euro against the US Dollar. This time the chart provides a daily picture, as opposed to the weekly and monthly ones we looked at before.

EurUsd pair

A - the MACD slower line starts to rise, thereby putting the Euro in buy mode against the US Dollar. However, by the time the faster line moves down for the prerequisite two periods, signifying a pullback and hence a heads up for a potential buy, the slower line has started to fall at B.

C - Four days later the Euro starts to rally and another two days pass before the faster line provides the heads up signal for a possible short position at C. The same day also provides one of the thirteen candlestick sell patterns (a spinning top) that can be used for the timing of an entry, and even possibly for the placement of a stop loss on the short position. By the close of the second day the position is nicely in profit.

As this application of the MACD ought not to be used for exiting a position, you would need to have some other rules in place to manage the trade through to completion.

D - marks the turnaround in the market direction as gauged by the slower line turning up. The heads up for a buy arrives just four days later at E. This is accompanied by a bar chart buy reversal signal. Depending on your entry and stop loss management rules, this potential long position may have resulted in a loss (if your stop loss was too close to the market) or a profit using different stop loss rules.

Had you been stopped out on the second period after the reversal signal, that period itself was a candlestick buy signal allowing you to re-enter on the long side. The faster line had again moved down, but this time for just one day without breaking the low of the previous reversal buy signal.

From this you can see that you can devise a number of trading rules using this uncommon interpretation of the MACD. In almost all cases, the heads up signal will come when the market has had a pullback in the opposite direction to the main movement as defined by the direction of the slower line.

F - The second heads up for a buy arrives after the pullback in early October at F. There are a number of chart signals present that you have used for the timing of your entry on the long side. This opportunity lasted for a few days before another correction to the downside providing the next heads up for a buy at G.

The commencement of this rally was signaled by a candlestick chart buy pattern. Is there something to using chart signals for the timing of trades? Hmm, food for thought indeed.

15 min EurUsd pair

The final chart that we shall examine is an intra-day 15 minute chart of the Euro/US Dollar currency pair. This is a very popular day-trading market for thousands, if not hundreds of thousands, of speculators around the world. You have to be rather nimble with your orders when trading such a small time frame.

At both A and B, the slower line is heading down, the faster line has moved up for the required two periods, signifying the potential end of the correction. You will note that both times the market did resume its movement down until C. On that period, the slower line turns up indicating that you are looking for a heads up signal for a buy.

These occur at D and E marking the potential resumption of rising prices. And rise they did until this uncommon application of the MACD signals that the Euro/US$ has begun another movement down. It is interesting to note that the very high bar was accompanied by a bearish double divergence in the histogram of the MACD (not shown).

As the market continued its fall, G provides a heads up for a sell. This time the market kept on rising until the slower line turned up at H. This illustrates the fact that even this application of the MACD is not right all the time. After all, would it not be boring if it were?

In my mind, it is always important to understand the underlying principle behind any indicator, setup or even timing tool for that matter. In the case of this particular application of the MACD, there are two, related principles. The first one is that markets do have runs, both up and down. Some people refer to this loosely as a market trending up or down.

The second principle is that the market never goes in a straight, uninterrupted line, either up or down. There are always counter-movements that last for a number of periods. A commonly applied term for these counter-movements is a pullback or a correction.
By having a setup, or indicator, based on a sound principle I have found that the setup, or indicator, has a much greater chance of 'working' over a very long time. By this I mean that the trading idea will not be negatively effected by a market changing character.

In the bigger picture I believe that just as human nature has not changed over time, nor has the market, any market. Another of those universal truths at play.

In this article I have demonstrated a way of using a common indicator, the MACD, in an uncommon fashion to determine both the beginning of a movement and when the, almost inevitable, counter-movement has potentially ended courtesy of the heads up signal. The examples that I have used have covered a number of different markets as well as different time frames, thereby satisfying my Universality Test. I have also suggested several ways of determining exactly when to enter the market after the heads up signal.

Specifically they are a number of bar charts patterns as well as candlestick patterns. It has been my experience that these patterns, when combined with a valid setup signal, I can get into a market well and truly before a movement becomes self-evident. In this fashion my losses are greatly reduced, especially when compared to using traditional trend-following and breakout trading techniques.

Alternatively, you may choose to use Larry Williams %R indicator as a trigger to tell you when to enter the market. There are other indicators such as Dr George Lane's Stochastic oscillator that can also be put to work for timing your entries.

The next stage of your taking this knowledge and turning it into a rule based trading system is to devise a stop loss management set of rules and perhaps even trade management rules that allow you to add to winning positions and take partial profits along the way.

I trust that you are beginning to really appreciate that success trading is about far more than 'when do I buy' and 'where do I sell'!

As is my want, I urge you to thoroughly backtest the uncommon application of the MACD on the market, or markets, that you are trading, or wish to trade. If you have any questions or comments, as usual, please do not be shy about sending me an email. Even though I reside in Vanuatu, a tiny country consisting of 83 islands in the South Pacific, the internet does work (mostly) and provides my umbilical chord to the rest of the world.




The Journey continues!

Is this part of your journey?