How to use technical indicator to estimate p, in the expected return formula

In previous article we talked about using expected return formula to make trading decision (Read more here).  It is easy to calculate the expected return but, getting the right number for each variable in the formula is not so straight forward.

MACD was created by Gerald Appel in the late 1970s (Read more here).  It is a good technical indicator to determine the chances of trend reversal, or in another word, the chances of generating positive return in either long or short position.  Today, we will just focus on the long position.

The technical chart below (Chart 1) is the AirAsia chart from April 2015 till June 2016.  During the period from June 2015 to end of August 2015, the stock price was hammered down rapidly.  Then at the beginning of September 2015, the stock price trend was reversed.  The MACD indicator clearly showed that chance of the trend reversal was getting higher.  What are the criteria for us to confirm the MACD divergence?  The following method was fine-tuned by a popular China trader Xu Xiao Ming (Read more here).

Chart 1

MACD divergence confirmation criteria (long position)

1.       Closing price at new low but both MACD line (blue) and signal line (red) do not make new low.

2.       There are three distinctive MACD bar valleys and hill formation, as indicated in the chart as number 1, 2 and 3.

3.       The MACD bar in valley 3 must be shorter than the MACD bar in valley 1.

4.       During the period transitioning from valley 1 to valley 3, both MACD and signal lines did not cross zero line.

5.       The entry point is near the valley 3 where the MACD line cut above the signal line.

I have done many data collection on the accuracy of the MACD divergence using historical data and histogram analysis (Read more here), it is quite good to be used as the estimation for p in the expected return formula for Index but not for individual stock.  Table 1 below is the summary.

Table 1

Chart type	Chances of trend reversal, p (Index)	Chances of trend reversal, p (Stock)
15 minutes chart	50%	Not reliable
30 minutes chart	60%	Not reliable
60 minutes chart	70%	Not reliable
Daily chart	80%	50%
Daily + minutes chart coincide	90%	50%

My data only cover Hang Seng Index, Shanghai Index, FTSE China Series Index (see Chart 2), and Bursa Malaysia individual stock.  I do not have sufficient data for Bursa KLCI or EMAS index as for the past three years, no MACD divergence was formed.  Readers who are interested to help collect data on other indices or individual stock can contact me via email or leave your comment.  We can form a database for better trading!  J

Chart 2

To keep the article short, and easy to digest, I will discuss how to use technical chart to estimate R_W and R_L, to complete the whole expected return formula in another article.

Disclaimer:  The above technical analysis do not imply any buy or sell recommendation.   The author disclaims all liabilities arising from any use of the information contained in this article.