Trend-following is the primary method through which profit is made in trading. Buying when stocks or currency are cheap and selling when they are at their most expensive point is the desire of every trader. Knowing these points, however, is closer to gambling than most of them would like to admit.
A game of nerve and risk follows. The uncertain situation can only be resolved by following a set of indicators. Through calculations and the processing of immense amounts of data, these strive to identify and predict trends, making trades safer and more profitable.
Identifying and acting within a trend is key. Once a trend is evident, joining it late – thus paying high – only for it to end quickly can be disastrous. The trader will be left with a cheap position for which he paid more, meaning he will incur losses. Similarly, selling too early, while the trend is still going strong, means that the trader will not gain as much as he could have.
Dumb luck, gut feeling or experience can now be replaced by high-functioning programs that calculate, identify and predict current and future trends. With robotic advisors in the making and automated trading a reality, the markets are increasingly replacing the emotional man with cold and efficient calculators.
Indicators are the first pieces of proof that technology is inescapably impacting the world of finance. The following two indicators are some of the most commonly used by professional traders.
MACD stands for Moving Average Convergence Divergence, and it is a trend-following momentum indicator. Ever since its development in the late ‘70s, it has been used for identifying new trends. As being aware of a trend is translated to making profits, this simple tool is particularly useful for traders.
This indicator takes into consideration faster-moving averages, slower moving averages and the moving average of the difference between the two. As such, an MACD histogram signals the difference between fast and slow moving averages. Studying it, tendencies of divergence and convergence are made clear whenever the moving averages get closer or further apart.
The interplay between these two lines functions as a prediction for future trends. By using the MACD, traders are able to profit from trend-following to the maximum. However, the indicator has a built-in disadvantage. Uptrends are usually jump-started by an initial surge that causes momentum. This is well identified by MACD at the beginning of the trend. The problem is that the initial surge is never sustained throughout the entire trend. As a result, MACD begins to decline from showing high levels, even though the trend is still going.
The time frame is of maximum importance for using MACD. While it is usually calculated through the 26-day and 12-day exponential moving average, it is the 9-day EMA of the MACD that acts as the trigger for buying and selling. When the trigger line surpasses the MACD line, a buy signal is sent. Inversely, the falling off the line means that the trader should start betting against the stock.
While the 12, 26 and nine format of MACD is commonly used for weekly charts, the indicator can be applied to daily or monthly charts as well.
When using MACD, a professional trader:
Buys when the MACD faster-moving average line crosses the signal line from below the top
Sells when the same MACD fast line crosses the signal line from top down or when MACD is above the zero line for a long time and then begins to fall top down
Short for Oscillator – Moving Average, the OsMA indicator represents the degree of variance between an oscillator and its moving average. In continuation of the most popular indicator, the MACD, it takes its primary line – the faster-moving averages – as an oscillator, turning its signal line into the moving average.
Effectively, OsMA looks at the distance between the faster-averages line and the MACD signal line. This indicator ignores the current balance of power between buyers and sellers on the market that support or resist this trend. When the OsMA indicator goes into higher values, it suggests that purchases are stronger. Inversely, when it goes lower, it means that sellers are getting stronger. However, in both cases, “stronger” does not mean that either sellers or buyers overpower each other. It only means that their own strength is increasing.
An even further simplification of MACD, OsMA uses immediate, raw data to its own signals. When the slope goes up to high values, it gives the buy signal. Conversely, when it goes lower it means selling is recommended.
Built and backed by data, OsMA also works toward predictions. If the slope continues to spiral downward, it means that selling is the primary activity in the market. As a result, the price will continue to drop. The reverse is also true when the case for buying is considered.
When using OsMA, a trader:
Buys when OsMA stops falling and begins to move upward
Sells when OsMA stops growing and beings to fall
Both indicators have their strengths and weaknesses. The “blind spot” of MACD is the period immediately after a trend-setting surge in the market. Moreover, the indicator is not very good for identifying overbought or oversold levels. Without limits, it continues to extend beyond historical extremes that might be essential in predicting the way in which certain trends might go.
Similarly, the OsMA indications are far from certainty. Using short-term data, OsMA establishes the current trend within the market and makes predictions more exact. However, it does not pay much attention to crossovers, so its coupling with MACD is essential.
The two indicators also handle new highs and lows well, establishing new points for their calculations. The wider divergence levels also allow traders to catch the main points at the beginning of a new trend and to hold their positions for longer, making bigger gains.
Being able to read seemingly complex indicators, which in turn consider an immense web of historical and present data, is the new necessity of trading. Without these modern tools, trading today is not unlike being the only blind person left in a world in which anyone can see much clearer. Even though still subject to chance and sudden changes, the MACD and OsMA are a step toward removing much of the risk from trading.