Simple is better, especially for the beginning trader. It is more important to know a few indicators inside and out than it is to know very little about every indicator.
With that idea in mind, let’s look at a very simple system that uses just one indicator, the MACD.
The 200 SMA MACD System
One of the most basic systems that uses the MACD indicator is the MACD/200 SMA system. This system uses the 200 period Simple Moving Average (SMA) to determine which direction the long term trend is moving, and then uses the MACD/Signal Line crosses to determine entry and exit points.
If the market being traded is trading above the 200 SMA, then any time the MACD Line crosses above the Signal Line is considered a buy signal. Anytime the MACD Line crosses below the Signal Line creates a sell to exit signal.
Reverse the signal rules if the market trades below the 200 SMA. The MACD line crossing below the Signal Line is considered a short signal. An up cross signals that the trader needs to cover the position.
Chart and Instrument: Any
Market Condition: Trend
Go long when:
Price closes > 200 SMA
MACD crosses up
Go short when:
Price closes < 200 SMA
MACD crosses down
Exit long when:
MACD crosses down
Exit short when:
MACD crosses up
Adding the 200 SMA enables the system to ride major trends. It makes sure that you won’t be shorting a market that is in a strong uptrend, or buying a market that has been declining.
While this adds some security, the system will still struggle during non-trending periods. This could cause quite a bit of whipsaw action during sideways trending markets.
Edward wrote about creating a specialist Expert Advisor on Friday. This SMA-MACD system is a perfect example of why it’s so hard to create a jack of all trades strategy.
You know where this strategy makes money – in trends. Apply the high level filter yourself when trading. Is this market trending? If yes, apply the strategy. If not, then don’t. They are simple rules for a complex world.
If we use the chart of the SPY above as an example, the system would have given a buy signal in late November, right after the SPY broke above the 200 day simple moving average. The system would have logged some nice profits before generating a sell signal as the market pulled back at the end of the year.
After about one week on the sidelines, the system would have generated another buy signal as the market exploded to start the year. It would then catch the big move during the entire month of January, then gone to cash in February.
After avoiding the pullback at the end of February, there was a buy signal that captured the strong trend during the first two weeks of March, then a sell signal for the second half of March. The system then generated another buy signal in early April.
Demonstrating that this system works during a four month stretch of a strongly trending market does not mean this is a proven strategy. You know from the strategy basics that it only works in trends. However, if you are looking to build a trading system, this makes for a simple and convenient starting point.
As you can see, the MACD (Moving Average Convergence/Divergence) indicator draws below a normal chart and contains a histogram and two lines.
The black line, which is the slightly thicker line on most charts, is called the MACD Line. The default MACD Line represents the different between the 12 and 26 day Exponential Moving Averages. These are the first two variables that the trader can adjust. I recommend using the default EMAs to keep this system simple.
The second line is called the Signal Line. This is the third variable that the trader can adjust. It is normally a 9 day EMA. The histogram measures the difference between the two lines, which is why its value is zero when the lines cross.
The primary advantage of the MACD indicator is that it will lag the market action slightly less than a simple moving average crossover system. Like most indicators, there are times when the MACD performs very well, and there are times when it will generate a number of false signals. It can be an excellent tool when applied to trending markets, but offers little value in non-trending markets.