Once we become familiar with the most common trading tools in the financial markets, it is important to start thinking about ways we can use these tools. It’s not enough to simply base trading decisions on the readings of the base indicator itself and that’s why more advanced traders have devised ways to look differently at the behavior of the MACD (Moving Average Convergence-Divergence indicator) to plan trading. Let’s look at two of the best examples: Crossovers and Divergences.
Crossovers at MACD
When using the MACD, one of the main methods among traders is the use of crossovers as the main generator of trading signals. In a bullish scenario a trading signal is generated when the MACD rises above the Signal Line. This signal is telling traders that the momentum is changing in the underlying price activity and that there is a greater likelihood that the chosen currency will rise in value in the future. In the opposite scenario, when traders are looking to sell in bearish situations, they should expect the MACD to drop below the Signal Line. This tells traders that the underlying momentum in their currency pair is changing direction and is much more likely to continue downward in the future.
“Traders based on this Crossover method,” said Haris Constantinou, a market analyst at TeleTrade, “often prefer to wait for confirmation of the cross below the signal line before starting a position. Confirmation can be seen when prices rise above the price resistance (for bullish positions) or fall below the support (for bearish positions). Failure to follow these rules can lead to “false starts” and may lead to traders having to absorb unnecessary stop-losses.
Since traders should avoid false exits of this type (or, on the contrary, initiate positions too early), the MACD indicator can be of great value to traders looking for ways to view price activity objectively.
Divergences in the MACD
While crossovers are perhaps the most common method of taking advantage of the benefits of MACD, there are other methods as well. The next common use of the MACD indicator is to use it as a means of identifying divergences. For those unfamiliar with the term, the divergences refer essentially to situations where price activity differs or “deviates” from what is seen in a reading of the indicator. For example, if prices are making a new high while, at the same time, the indicator is failing to make a new high, we have a divergence.
When divergences are observed, the current price activity should be viewed with some scepticism because there is no confirmation, or agreement, between the price and the reading of the indicator. This type of situation often leads to reversals. Once we understand the concept of “Divergence”, we can take a look at the bullish and bearish scenarios, so that positions can be placed when signals are generated. Divergences and Crossovers offer traders new ways to see the traditional MACD indicator.
Most traders are familiar with the use of Fibonacci ratios as input and profit taking, but few have considered stop loss placement with Fibonacci. The use of unconventional methods to establish stop loss levels can have a surprisingly positive effect on profitability, and if a method can be found that is both unconventional and reliable, a serious advantage can be discovered. The placement of stops with FIBS can be such a method.
The purpose of stop loss is to limit the risk. Most traders tend to consider that a stop-loss should be placed at the point where the trade becomes “bad”, i.e. a negative point which if reached means that it is likely to continue to go in the wrong direction of trade. Operators also tend to set the stop loss in a very conservative way, telling themselves that traders need a “breathing space”, as they put the stop loss one pip above or below the trigger sail or the high or low swing. This depends to a large extent on the risk level of the trader and his trading style.
The best traders often spend little time in negative territory. This is not always true, but if one looks at a wide sample of historical trades produced by most types of strategies, especially breakout strategies, a positive correlation of about 0.25 is usually between immediately thriving trades and ultimately winning trades. This has serious implications for the traditional stop loss adjustment approach so that traders have room to breathe, as in a disproportionate number of winning trades no room to breathe is needed!