Ultimate Algorithmic Trading System

We will discuss moving averages in the last part of this chapter, but a little
knowledge of averages is necessary to fully grasp the MACD. A trend change is
usually indicated when a shorter (more sensitive) average crosses above/below
a longer (less sensitive) average. Unfortunately, moving average crossovers lag
current market conditions, and here is where the real beauty of the MACD is
revealed. The histogram component can quickly reveal when the difference between
the two moving averages (MACD) and the smoothed version of MACD (trigger)
is converging or diverging. Convergence means the MACD line and its associated
trigger are coming together and divergence means simply the two are growing apart.
As prices of an instrument increase, the short-term moving average will grow quicker
than a longer-term average. The MACD histogram will reflect this momentum. As
prices start to slow, the histogram will start moving in the opposite direction.
Calculation of MACD using 12-day and 26-day moving averages:
1. Calculate a 12-period EMA of price for the chosen time period.
2. Calculate a 26-period EMA of price for the chosen time period.
3. Subtract the 26-period EMA from the 12-period EMA.
4. Calculate a 9-period EMA of the result obtained from step 3.
This 9-period EMA line is overlaid on a histogram that is created by subtracting
the 9-period EMA from the result in step 3, which is called the MACD line, but it
is not always visibly plotted on the MACD representation on a chart.
A trading algorithm can be derived by waiting for the histogram to form a two-bar
high pivot (two bars to the left and to the right are shorter than the center bar) and
then entering a short position. Momentum has been positive but it is beginning to
slow. A long position can be initiated when a two-bar pivot low is formed in the
MACD histogram. Figure 2.12 shows how the pivot points in the histogram can
initiate trade signals.
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STOCHASTICS AND AVERAGES AND RSI! OH, MY!
FIGURE 2.12
Histogram pivot points can initiate trade signals.
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