The Signal Line Crossover Trading Strategy
In the last article of our MasterClass on MACD, we talked about how to implement the centreline crossover trading strategy on Mudrex. Checkout the last article if you haven’t already. In this article, we’ll be talking about the signal line crossover trading strategy along with the concept of take profit and trailing take profit. We’ll be discussing the following topics in-depth with trading charts and screenshots of Mudrex’s strategy canvas wherever necessary:
- MACD Line
- Signal Line
- Strategy Description
- Take Profit Implementation
- Trade Analysis
As we talked about before, the MACD Line is the difference between the shorter and longer period EMA. The mere value of the MACD line, positive or negative, can indicate the sentiment of the market. Exponential Moving Averages (EMA) of “price” can be interpreted as defining the trend of the market. Crossovers of MACD with the centreline can therefore tell us about changes in price movements rather than trend reversals.
To use the MACD indicator to detect trend reversal we need to consider the Exponential Moving Average (EMA) of the “MACD Line” instead of the price as described above. The signal line is a 9-day EMA of the MACD line. As a moving average of the indicator, it trails the MACD and makes it easier to spot MACD turns. Changes in MACD line movements can hence be interpreted for trend reversals and thus buy/sell signals can be generated at the crossovers of the MACD line and the Signal line.
The look-back periods of shorter and longer EMA to define the MACD Line can be set on Mudrex. The third parameter is the look-back period of the EMA associated with the Signal Line. By default, a setting of (12, 26, 9) is used which means MACD Line is calculated as the difference of 12-EMA and 26-EMA whereas Signal Line is calculated by taking 9-EMA of the MACD Line.
However, you can change it as per your trade frequency and risk appetite. Traders can consider using the setting MACD(5,42,5). When used on the daily chart, this sets the fast EMA to a week’s worth of data, the slow EMA to two months’ worth of data. Other popular pairs are (24,52,9) and (34,89,34).
We will be using the default look-back periods of (12, 26, 9) for the sake of simplicity. MACD line less than Signal line is an indication of an overall downtrend whereas MACD line greater than the Signal line is an indication of an overall uptrend. When the MACD line crosses above the Signal line, it means that a trend reversal from bearish to bullish can be anticipated. On the other hand, when the MACD line crosses below the Signal line, a trend reversal from bullish to bearish can be anticipated. Therefore the buy and sell signals can be generated as follows-
Buy when: MACD crosses up Signal [Bullish crossover]
Sell when: MACD crosses down Signal [Bearish crossover]
Building on Mudrex
Compare block for MACD crossing up Signal looks like this:
Compare block for MACD crossing down Signal looks like this:
Take Profit (TP)
With a take-profit order, if a share price rises to a certain set level, the position will be automatically closed at the price of the take-profit order. Most traders use take-profit orders in conjunction with stop-loss orders (SL) to manage their open positions. If the security rises to the take-profit point, the TP order is executed and the position is closed for a gain. If the security falls to the stop-loss point, the SL order is executed and the position is closed for a loss. The difference between the market price and these two points helps define the trade’s risk-to-reward ratio.
Trailing Take Profit (TTP)
Traders use a TP order only when they want satisfactory gains and are sure that the uncertainty with the market price of the security will increase after a certain jump in price. The stock could start to breakout higher, but the TP order might execute at the very beginning of the breakout, resulting in high opportunity costs. To outmanoeuvre this opportunity cost, trailing take profit can be used. The TTP is set as a trailing percentage on Mudrex, and if the price is breaking out above the take profit limit, the TTP will trail the upward moving price and execute the trade only when the price goes down by the set TTP percentage. All this is happening only after the price breaks above the TP order thus booking in more profits than exiting at TP preemptively.
In our strategy, we will be using a TP of 10%. This would mean that a long trade will exit as soon as the price rises 10% above the buy price. Using a TTP of say 2% would mean that now the trade will only exit once the price breaks above TP and then drops down by 2%. The values set are solely for experimental purposes and you can choose your own values depending upon the market volatility and risk tolerance by backtesting on Mudrex.
The overall strategy looks somewhat like this:
The buy signal (B) shown in the chart above was generated when MACD crossed up Signal line indicating a possible uptrend in the future. However, as soon as the price rose more than 10% of the buy price, the TTP started trailing the price. At the red candlestick, when the price fell more than 2% of the peak price, the TTP sell signal was generated (marked as P in the chart above).
With a suitable usage of stop-loss and take-profit combination, you can make the most use of your designed trading strategy by minimizing risk and all this can be automatically done on Mudrex. In the next article of our MACD MasterClass, we will be talking about a slightly complex method of using MACD in multiple time-frames.
A few quick references below: