by Vadim Pokhlebkin
Updated: October 29, 2014
[Editor's Note: Adapted from a collection of instructional reports for traders by EWI's senior instructor and Trader's Classroom editor, Jeffrey Kennedy. Below is the text version of the video.]
Trend indicators are computerized studies that you often see at the bottom of price charts. The most common studies are MACD, Stochastics, RSI, and ADX, but there are literally hundreds of technical indicators out there.
Of all those, one of the most useful indicators is MACD, Moving Average Convergence-Divergence. You can see an example of MACD in action in this chart of coffee futures:
MACD, which was developed by Gerald Appel, uses two exponential moving averages, 12-period and 26-period. The difference between these two moving averages is the MACD line (the thin blue line in the chart above). The trigger, or Signal Line, is a 9-period exponential moving average (the thick line in the chart above). MACD settings are usually expressed as 12/26/9… which is easy to misinterpret as a date, so be careful.
The simplest trading rule for MACD is to buy when the MACD line (the thin line) crosses above the Signal Line (the thick line), and to sell when the MACD line crosses below the Signal Line. This chart of coffee highlights these very basic buy-and-sell signals:
Many people use MACD to generate these simple buy/sell signals. However, if you combine MACD with Elliott wave analysis, you get an ever better technical indicator -- in three very practical ways.
First, MACD helps you identify the end of third waves, the most powerful moves within the 5-wave Elliott wave sequence. Often, an extreme reading in MACD will correspond to the extreme of wave three. Here is an example of that in sugar futures:
You can see how a peak in MACD is in line with the top of wave three. Then, MACD pulled back to zero in wave four before turning up in wave five. And although sugar prices were higher at the end of wave five than at the end of wave three, MACD readings during wave five fell far short of their wave three peak. That warned you that momentum was weakening -- in other words, wave three, the strongest part of the trend was done, and it was time to start thinking defensively.
The second way to combine MACD with Elliott is to use it to identify the end of corrective Elliott wave formations. In this chart of live cattle futures, you see a typical three-wave decline, labeled ABC. If you examine MACD, you'll see that although wave C fell below the end of wave A, the MACD reading for wave C was above the level of wave A. In other words, momentum never fell as low as the price, warning you that the price was about to turn higher.
A third way to combine MACD with Elliott is to use it to identify Elliott wave triangle patterns. In this chart of pork belly futures, you see a contracting triangle wave pattern, labeled ABCDE. But look: MACD traced out a similar pattern, and it's concentrated around the zero-line.
In other words, triangles in price often correspond to a flattened MACD near the zero-line.