Our model is a simple, straightforward application of the MACD model. Anyone familiar with the method will easily observe that in our charts nothing new was revealed. Therefore, this section does not explain what is MACD and how it is used, as there are plenty of resources freely available that explain in much more detail how to apply the MACD indicator. We will explain here what differentiates our method from the standard MACD and how we use it to determine the peaks and throws of the Dow-to-Gold-Ratio.
While we do not alter the basic concepts of the MACD, our method is differentiated by the settings we are using.
In a traders’ world, the most use settings are:
• Short Term Moving Average: 12 periods;
• Long Term Moving Average: 26 periods;
• Signal Line: 9-period Moving Average of the MACD.
According to the information available about MACD history, these settings stem from the days when this indicator was developed. [http://www.forexabode.com/forex-school/technical-indicators/macd] In those days, a trading week consisted of six days, Monday through Saturday and a calendar month had in average 26 working months. Therefore, the 12-period seemed to be a reasonable choice for the Short-Term Moving Average because it was calculated based on the closing values registered during the last two weeks. The same can be said for the 26-period, calculated based on the closing values registered during the last month. And the 9-period used for the Signal Line, represented the average of the MACD values of one and a half week.
Many resources explaining the MACD indicator recommend using the default settings (12, 26, 9) because they are widely used, the argument being that most traders use the same settings and make decisions based on these settings. Therefore, using different settings may lead the individual investor out of sync with the crowd.
When we started working to develop a decisional model based on MACD indicator, we understood that the standard settings are no longer suitable for today’s trading. Of course, the first observation is that a trading week has only five days and a calendar month has approx. 22 business days. But there are other reasons beyond that.
At the time when the MACD indicator was developed, the stock quotes were reported in fractions with 1/8 dollar spread. The decimal evaluation, where a stock price could increase and decrease with one cent spreads, was introduced as late as year 2000. Build-up of decentralized exchanges and trading platforms allowed a significant increase of intra-day trading – a source of increased volatility. These tendencies have been accentuated in the last years by high-frequency traders, companies that use computer algorithms to place “Buy” and “Sell” orders.
While all these are good reasons to use MACD as a reliable indicator that filters out volatility and noise, we do not see why it is necessary to keep the default settings.
As we strongly support ‘contrarian investing philosophy’, we decided to search for alternative settings that would give us better indication of market peaks and throughs.
As mentioned before, our method differs from the standard MACD indicator in that we do not use the default settings for STMA, LTMA and Signal Line. In addition, we use neither the linear, nor the exponential moving average, which are the most used formulas for calculating the moving average.
During the process of fine-tuning the method, we have found that using the linear moving average for calculating the Signal Line values is too slow as an indicator of trend changes; therefore, opportunities cannot be identified at the optimum stage. On the other hand, the exponential moving average is much faster, but its usage increases the risk of false signals. Therefore, we are using a modified version of a weighted moving average.
Finally, we limit the usage of our model to monthly, weekly, and daily charts, based on closing values. In this way, we determine the short-term trend (daily closing values), the medium-term trend (weekly, closing values at the end of Friday trading day) and the long-term trend (monthly, closing values in the last trading day of the month). While MACD can be applied to any data series, our purpose has never been to use it for intraday trading. On one hand, the fluctuations are very large during the day, with extreme volatility caused, among others, by High Frequency Traders. On the other hand, intraday trading requires constant monitoring of the price moves and, although technology makes possible to automatize the tasks, the amount of time dedicated to trading is significant.
It is important to be aware of the fact that MACD is an excellent indicator for eliminating noise and identifying trends. Still, it is a lagging indicator, being based on historical data. Therefore, MACD cannot be used to predict or anticipate the direction of the market for the next period (day, week, or month).
A very good understanding about how we use the MACD indicator to determine the trend changes can be achieved by looking at some of the most significant Historical Moments. Please click below.