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MACD Gives False Signals

MACD Gives False Signals
July 22, 2015 Martha Stokes CMT

Lists Best & Worst Market Conditions For Using MACD

MACD has several key elements that are important to know if you intend to use this indicator as a primary entry signal for buying long, selling short, or options trading. Despite the fact that MACD is extremely popular, empirical evidence shows that most retail traders using MACD are not consistently successful. Many are baffled by the fact that sometimes MACD works, while other times it fails completely. They endure frequent whipsaw trades that quickly wipe out small gains because MACD gives false signals during certain Market Conditions.

TechniTrader creative image for MACD with three colored lines in graph and hand pointing to crossover signalThe first thing to understand is that MACD is a Price and Time momentum indicator. That means that the price must move before the signal can form on MACD. Therefore MACD cannot lead price as several of the quantity based indicators do. Consequently you would be entering the stock after the initial price move up or down, which can be an asset or liability depending upon the Market Conditions and Trading Conditions at the time.

A Trading Condition is the trading environment at a particular point in time such as Intraday, Daily, or even Weekly. Market Condition is the overall type of price action that is most prevalent among the 6000+ stocks listed on the Stock Market Exchanges. These are two entirely different conditions but work in harmony as well.

As a momentum Price and Time Indicator that employs two Moving Averages to create the crossover signal for an entry.

List of the best Market Conditions for MACD to work optimally are:

1. Moderately Trending
2. Velocity

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However Moderately Trending Conditions occur about 15-20% of the time, and Velocity Market Conditions occur about 5-10% of the time. Moderately Trending markets occur somewhat more often but rarely last as long as a Platform Market Condition, which also handicaps a trader. Moderately Trending Market Conditions tend to come after a Platform Market Condition, before a Velocity Top and after a Bottom that moves up with velocity briefly.

One of the reasons so many traders experience whipsaw price action when using MACD is they are attempting to use it in one of the 4 Market Conditions that feature Sideways price action most of the time.

List of the sideways Market Conditions in which MACD fails, which makes them the worst for using this indicator are:

1. Platform
2. Bottoming
3. Topping
4. Trading Range

During Platform Market Conditions which occur 40-50% of the time, MACD gives false signals because the tighter price action is controlled by Dark Pools who use sophisticated order processing venues that do not move price. It is contained within a narrow price zone where they have decided to buy or sell. Consequently using MACD during a Platform Market Condition will cause poor entry signals, whipsaw action, or losing trades because the runs are not momentum as MACD requires. Instead this is sideways action with small brief runs that do not net sufficient gains for the late entries MACD provides.

See the chart example below which shows a Platform condition where MACD gives false signals, and also a Velocity move out of a Bottom where it performs best.

TechniTrader - A TC2000 Chart example shows Platform condition where MACD gives false signals.

MACD requires that the price moves up or down before it will signal a crossover entry. If a trader attempts to use MACD during a Platform Market Condition which is sideways, the run may only last 1-2 days and will be very small price movement. This is insufficient for MACD entries, which rely upon a run to continue to move several days or sufficiently in one day for profitability.

During a Trading Range Market Condition fails completely as Gerald Appel did not intend MACD to be used for selling short. In addition several studies of MACD in a sell short environment concluded that it was not an ideal indicator for selling short, which is due to how price moves to the downside. It usually starts with a huge downside move on High Frequency Trading HFT activity, then quickly diminishing as the stock moves down which is just the opposite of an upside Momentum or Velocity Market Condition.

Summary

The more you understand MACD and the Market Conditions in which it is designed to work optimally and those in which MACD gives false signals, the better you can make use of this indicator.

MACD was designed during a period when the Market Condition was moving out of a Bottom with Velocity, and it functions best when used in that context. However Bottoming Market Conditions occur infrequently, and Velocity Market Conditions last the shortest length of time of all the 6 Market Conditions. So using only MACD severely limits when you can trade. Also as a mere Price and Time indicator, the most important data stream which is Volume is not included in MACD indications.

Trade Wisely,

Martha Stokes CMT

TechniTrader technical analysis using a TC2000 chart, courtesy of Worden Bros, Inc.

Chartered Market Technician
Instructor & Developer of TechniTrader Stock & Option Courses

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Martha Stokes, CMT is co-founder and CEO of TechniTrader. She is a retired professional Buy-Side Analyst and was awarded the Chartered Market Technician designation for her thesis, "Cycle Evolution Theory." Martha is a passionate teacher of the financial markets and a prolific writer, having created over 40 stock, option, and financial market courses.