Analytical Toolbox: Varying Indicator Settings
August 15, 2008
Traders are pretty much aware that markets tend to head downwards more quickly than they move upwards. With this in mind what does it mean for your indicator settings? In July this article series focused on the trading techniques and philosophies of Andrew Cardwell—a seasoned trader who uses the Relative Strength Index [RSI] in ways that impressed even Welles Wilder. While Cardwell has determined that Wilder’s default setting of 14 was optimal, does this mean traders should use the default settings for all indicators?
Each trader needs to decide which settings work best for the indicators they use. When you deviate from the default setting, be sure you have a specific reason for changing it and that you recognize the impact it will have on your alerts and signals (whipsaws or delays). Ideally changes you make to your indicator settings reflect time frames that suit your trading style. One trader’s short-term position may be another’s long-term one.
Moving Average Convergence Divergence (MACD)
MACD is a unique indicator that combines a leading tool with a lagging tool. MACD uses the rate of change for two exponential moving averages (EMAs) and then creates a signal line with a second smoothing process. The indicator was created by Gerald Appel and is widely available on different charting packages.
In Appel’s book Technical Analysis Power Tools for Active Investors, he uses a few different settings for MACD regularly, but indicates other combinations remain valid. As a general rule of thumb, he suggests using a long EMA that is two to three times the short EMA. He also comments that when using MACD as a sole indicator for trading, signal line crosses that coincide with MACD reversals represent stronger buying/selling opportunities. So when MACD is declining and is below the zero line, a reversal upward with a signal line cross is a better buy signal than a subsequent cross that occurs as the indicator trends upward.
Finally, at the heart of the discussion: are there times when you want to change those default settings (typically 12-26-9 for MACD)? Appel uses faster entry and slower exit combinations when conditions are generally bullish and the same entry and exit speed when markets are generally bearish.
One approach a trader can use to distinguish longer-term bullish and bearish conditions is the relative position of two MAs. As an example, when the 50-day EMA is above the 200 day EMA, conditions are defined as bullish. A shorter-term trader may use a 10-day and 30-day SMA combination. Remember to stay true to your style when it comes to defining these periods.
Testing It
One of the best ways to check an approach that varies indicator settings by market time is to perform a system test, even if you choose to use the indicator as guidelines for a trade approach or simply for market analysis. A variety of tests will be run over the next week attempting to replicate both Appel’s indicator speeds by market and rules of thumb for the best results.
Other Indicators
Consider the tools you use on a regular basis and how they respond under bullish versus bearish conditions. If you believe varying the indicator warrants a look, you may want to evaluate the different period of time it takes for uptrends and downtrends to complete or consider a cycle approach similar to Wilder’s technique for his selection of a 14-day for the RSI (represents half of a 28-day cycle).
To access other articles written by Clare White, please click here.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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