In our previous post, Getting Started with MACD: A Simple Introduction to Moving Average Convergence Divergence, we explored the fundamental aspects of the MACD indicator. You learned that one of the practical uses of MACD is the crossover, that is, when the MACD line crosses above the signal line, it's often inferred as a buy signal, while a crossover below the signal line suggests a sell signal. However, a key challenge with relying solely on MACD crossovers is the potential for false signals—especially in a sideways market where the MACD line fluctuates frequently around the signal line. Take a look at the chart below.
The chart above is daily chart of MARUTI . You can see in the chart that MACD gives many false signals (as shown by black arrows in the chart) and if you have traded based on those signals you would have gone through several losing trades.
So, the question that needs to be answered now is how can you proceed with MACD crossovers to reduce these inaccurate signals and make the most out of MACD crossovers? In this post, we’ll dive into a stock trading strategy that filters out imprecise signals. The principle behind this strategy is- by aligning your trades in the direction of a trend better trading positions can be held.
To effectively use the MACD, it's critical to realize that it's based on moving averages—a trend-following indicator. This means MACD tends to be most accurate when the market is trending. By identifying the broader trend first and then applying MACD crossovers that line up with that trend, you can significantly improve your trading outcomes. Let’s break this process into clear, actionable steps.
Step 1: Identify the Current Trend in the stock
Before diving into MACD signals, establish whether the stock is in an uptrend or downtrend. Here’s how you can do that:
-For an Uptrend: Look for stocks where the current price is above the 50 EMA (Exponential Moving Average), and the 50 EMA is positioned above the 200 EMA. This layout indicates a strong uptrend. When these conditions are met, it suggests that the stock is experiencing upward momentum.
- For a Downtrend: Screen stocks where the price is below the 50 EMA, and the 50 EMA is below the 200 EMA. This setup signals a downtrend, meaning the stock is under bearish pressure.
While analyzing a trend you should also pay attention to the inclination of 200 period EMA. An upsloping 200 EMA is suggestive of an uptrend while a downsloping 200 EMA indicates a downtrend.
Check out the images below for visual representations of these trend indicators:
The chart above is a daily chart of ICICI and you can appreciate that price for the most part is above 50 EMA and 50 EMA is above 200 EMA. Additionally, you would notice 200 EMA is inclined upward further suggesting the stock to be in an uptrend.The image above is showing daily chart of UPL and you will notice that the price of the stock stays below 50 EMA for the most part and 50 EMA lies below 200 EMA. Also, you would notice that 200 EMA is sloping downwards suggesting a downtrend.
I hope you have a better idea now to ascertain the trends behind a stock. Once you have recognized the trend of stock you now can move to next step as described below.
Step 2: Align MACD Crossovers with the Identified Trend
Once you’ve identified the trend, you’ll want now to align your MACD crossovers with it:
- In an Uptrend: Focus on bullish MACD crossovers and ignore the bearish MACD crossovers. This means you should only act on signals where the MACD line crosses above the signal line . This approach ensures that you are entering trades that complement the overall upward movement of the stock.
- In a Downtrend: Concentrate on bearish MACD crossovers and ignore bullish crossovers. This involves looking for instances where the MACD line crosses below the signal line . By doing this, you align your trades with the downward trend, increasing the likelihood of successful trades.
The following images illustrate how to identify and act on these crossovers:
The chart above is a daily chart of BHARTI AIRTEL and you can see the price of the stock is mostly above 50 EMA and 50 EMA is above 200 EMA suggesting an uptrend. Further, you would appreciate that by focusing on only buy signals ( Bullish MACD Crossovers) shown by black arrows you would have got many trading opportunities in the stock. Also, notice that if you have entered a trade in the opposite direction on bearish crossovers you would have incurred losses.
Step 3: Place a Stop Loss
To protect your investments from possible losses, placing a stop loss is crucial. Proper stoploss placement ensures that you don’t experience significant losses if the market goes against your position.
When you trade based on MACD crossover as described in the post your stop loss should be set at the nearest swing low for buying trades or at the nearest swing high for short selling trades. This strategy helps to restrict potential losses if the trade doesn’t go as planned. . The image below demonstrates how to set the stoploss levels effectively.
Now that you have learned how to set stoploss, we will now move on to next and last part of the strategy.
Step 4: Use Trailing Stop Loss and Set Targets to book profit
As your trade progresses and starts moving in your favor, it’s important to use a trailing stop loss. This tool adjusts your stop loss level as the price moves in your direction, helping you lock in profits while still allowing room for further gains.
Exit the trade when the trailing stop is hit, or if you notice a divergence between the price and the MACD. Additionally, you can use the Fibonacci extension tool to set price targets and exit the trade once these targets are met.
By following this stock trading strategy, you can significantly reduce the number of false signals and align your trades more effectively with market trends. This filtered approach will not only help you to make better trading decisions but also enhance your overall trading strategy with MACD.
I hope you liked the post. Stay tuned for more tips and strategies to elevate your trading game!
Post a Comment