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'Tis Better To Light a Candle Than to Curse the MACD

-- by Stubby Candles

Let's insert our tongue firmly into our cheek and take a little trip out to the wood shed where we shall administer some necessary and long overdue medicine to a most revered technical indicator.

No doubt you've heard the expression 'tough love.' Here we go a step farther and deliver a true technical trading reality slap!

Due to our fond affection for the ephemeral pip we will be directing our remarks to Forex traders, however these comments would apply equally well to traders of other markets, be it baseball cards, beanie babies or stocks.

We're here to skewer a sacred cow; that holiest of holy technical indicators, brought down from Mystery Mountain on the same tablet as the slow stochastic, but that's an article for another time.

We're speaking of the venerable Moving Average Convergence Divergence or simply MACD.

Enough articles have been written about the MACD to repopulate half the world's rain forests. Perhaps this will be the last. Although given human nature we'd have to forecast (without using the MACD) that more trees will needlessly die.

Here it is with both barrels: the MACD doesn't work. It's a glorified (if more complex) moving average, and moving averages are pathetic in forecasting price direction. They're great for telling you where, how and when price has already *been* -- but that's in the past, and there's a reason why they call this futures and not histories.

When applied over a long enough time frame a given moving average will be right half the time and wrong the other: the very definition of randomness. Jimmy the Greek would take a pass.

It's true that when paired with a second moving average of differing and reasonable periodicity (3:1, 4:1, 5:1, etc.) it is possible to maintain a modest positive trading expectancy over a sufficient number of trades, but a pair of endlessly crisscrossing moving averages will 'get you in' too late and just as often 'get you out' even later the vast majority of the time.

The MACD is a seductive indicator: by eschewing the simple moving average in favor of the exponential it is just advanced enough to entice the delight of the technically-minded, but not so arcane as to perplex the most propeller-driven beanied amongst us.

As for sex appeal, it's got two colorfully wavy lines crossing back and forth over each other (that's to keep you hypnotized), plus this really cool histogram in the middle for an added air of sophistication. Of course, you could program charting software to reprint the physical separation between *any* two moving lines, but so far only the MACD holds that claim, and it's an attribute that fascinates.

But the true allure of the MACD is that it requires -- ta, da! -- interpretation, in particular with regard to convergence or divergence from upper screen price action.

This fact alone has guaranteed the MACD perpetual placement in the pantheon of trading studies. For once a thing can be interpreted, it can be elevated to mystical status. From there it's just a short trip to worship which is where the MACD finds itself today.

MACD apologists would argue that we're being too harsh. That looking back there are countless times when the venerable work horse presaged a profitable move. No doubt. Of course that would also be true of tea leaves, drifting clouds or a spinning Coke bottle. Even a stopped clock is correct 730 times a year.

Alas, when used as an entry signal to the lush pip-filled world lurking just beyond the hard right edge of our computer screen, the MACD fails time and again as one would expect from any mathematically AVERAGED smoothing of PAST price action. If only one could trade in reverse!

Those inclined to count how many pips can fit on the head of a pin might wish to tweak their MACD in an attempt to make it even more 'predictive.' To our way of thinking this is like feeding a variety of performance enhancing drugs to a snail and watching to see if its meandering trail bends just a little more to our liking. But would it help us to know where the snail is going next? No, we won't have a clue, and the snail probably won't either.

The MACD uses as its farthest backward looking value 26 periods. On a 15 minute chart, 26 periods total 6 hours and 30 minutes. Fifteen minutes goes by pretty fast. There are 96 such periods in a 24 hour day, 480 in a 5 day trading week. A single period of 15 minutes is really just noise in the larger scheme of things.

Let's say it's 8:00AM New York time and I'm sitting here watching the 15 minute chart. What is the MACD doing? Still paying attention to what happened back at 1:30AM when New York traders were sawing wood.

I'm sitting here trying to get pips based on where I think the market is going in the next 15 or 30 minutes. I'm trying to get pips RIGHT NOW. What do I care where price was trading SIX AND A HALF HOURS AGO?

My favorite pair may have traded above the daily pivot during the Asian session, taken a bounce off strong long term resistance on the London open and dropped like a rock right into the New York session, leaving the MACD looking like a drunken hula dancer trying to outrun a volcano.

But I'm trying to divine what the Big Boyz are likely to do in the next 15 to 30 minutes, which means I need to understand what they were thinking 15 or 30 minutes ago, not in the middle of last night!

What I need is a predictive, laser-guided aiming system. What I get instead is a meandering lava flow with a bunch of crazy people trying to stay one step ahead. (Fortunately, most of those sprinters are serial pip donors, so I encourage their efforts and offer them a glass of water as they run by!)

In the end, the performance of moving averages and indicators based on moving averages will always be, well, average. So let's move on. What can we use to tell where price is going next?

Hah, I caught you. The answer is: nothing. There is nothing in existence that can tell us where price is going next. But there are a few simple tools that can tell us where price is *likely* to go next, perhaps 80% of the time or better.

They are:

1. The trusty trend line.
2. The reliable pivot point.
3. That freshest of all price footprints in the sand (or snow, depending on where you live): the candlestick.

These tools are not sophisticated and require no divinity degree to 'interpret.' In fact, they are not subject to interpretation. They are that stupid. They just sit there and look at you. And you look back, and you know what to do.

Don't believe me? [Using a demo account] try removing all indicators except for support and resistance (trend) lines, pivots and candlesticks. Here is a short list of what you do NOT need:

1. Moving averages
2. MACD
3. Stochastics
4. Parabolic SARS
5. Bollinger Bands
6. Chaos fractal alligator ichimoku ginko biloba fibo-tunnel price-ray vectors

First and foremost, learn to recognize candlestick action. We particularly love the hammer, the star and the Tower of Strength. We love them even more when they appear at pivot points or trend lines (for added epiphany think of inter-day trend lines as tilted pivots).

We have learned to recognize that price is a fickle thing that can change its mind faster than Liz Taylor changed husbands. That price moves like the people who move it. That like Sherlock Holmes who could walk into a room and know instantly how the killer had left (Answer: through the window. The candle on the table next to the window had been burning. A breeze had been blowing into the room. All of the dried wax had dripped down the candle opposite the window. The window had been open and that's how the killer had escaped), we can look at a candlestick and instantly see telltale marks of reversal and rejection (fear!), or momentum and continuation (greed!) that drive markets.

When candlestick reversals occur at places where fear and greed occurred before (tilted support or resistance = trend lines), or at anticipated price levels (horizontal support or resistance = pivot points), we have an extraordinarily high probability trade.

Price zigs. A hammer at key support!
Price zags. An evening star following a double top at key resistance!
And the MACD? It's still meandering through the charts like a picturesque mountain stream.

In the time it takes a MACD devotee to get out their compass and protractor and divine where price is heading next we can already be in and out of a profitable trade or two.

It may sound stupid, but it works for us!