07th Dec 2020

Why You Need to know the McGinley Indicator to Trade Crypto

Volatility can be a trades best friend and worst foe. While the opportunities are attractive during volatile markets, the risks of trading also increase. There are however a number of indicators that help traders under these conditions. You will have heard about Bollinger Bands and the Average True Range (ATR) indicators. You may even know about the Keltner channel that combines the ATR and the exponential moving average (EMA) indicators. But, not many will have heard about the McGinley indicator, nor know how to use it during volatile markets that cryptocurrencies often see.

The McGinley Dynamic Indicator was developed by John R. McGinley, who was a former editor of the Market Technicians Association's Journal of Technical Analysis and a market technician himself. He was dissatisfied with the results of moving averages and, throughout the 1990s, worked towards improving the model.

McGinley wanted to create a responsive indicator that would adjust itself automatically, in response to the speed of the market. The result was the McGinley Dynamic Indicator, which was published for the first time in the 1997 edition of Journal of Technical Analysis. To better understand the McGinley indicator, let's first look at the indicators its creator sought to improve upon.
In simple and exponential moving averages, the price action is smoothened by dividing the past closing prices with the number of periods. For instance, if you need to calculate the simple moving average for 10 days, the closing prices of the past 10 days are added and then divided by 10. The higher the smoothness of the average, the slower it is to react to price changes.

Therefore, a 50-day SMA would be slower in comparison to a 10-day SMA. In the 10-day and 20-day MA, the volatility can be high at times, making it hard to correctly interpret the price action. There can also be false signals during this period, when the prices get too far ahead. 

Exponential moving average is much quicker to respond to price changes, compared to SMA. This is because it is a weighted indicator. In EMA, more importance is given to newer data. This is a great indicator for identifying short-term trends. That is why many traders use simple and exponential moving averages together to determine entry and exit positions. But EMA can also leave out some data.
In the research conducted by McGinley, he found multiple problems with moving averages. The first was that the speed of the market is not consistent. It constantly slows down or speeds up. But the traditional MAs, such as exponential and simple moving averages, fail to take this characteristic into account. This problem is solved by the McGinley Dynamic Indicator, by including an automatic smoothening factor into the formula. This helps in making adjustments to the market movements. In trending markets, it speeds up the indicator, while in ranging markets, it slows it down. 

The other and even greater problem with traditional moving averages is that they use fixed lengths of time. The market can react to events at an extremely quick pace, which the moving average can fail to keep up with. The issue created in such cases is called lag. All moving averages, including weighted, exponential and simple, are prone to this issue. The lag affects the reliability of the results provided by these indicators. But the McGinley Indicator takes into account the change of speed of the market. Hence, the use of the word “dynamic” in its name This helps create a more responsive and smoother moving average line. 

The dynamic nature of this indicator also ensures that there is no large separation between the moving average line and the price line. This prevents whipsaws and price separation. However, it must be remembered that the lag is not completely removed. But, since the reaction to the market is quicker, it is more reactive than other types of moving averages. 
MDi is the current McGinley Dynamic
MDi-1 is the previous McGinley Dynamic
Close represents the closing price
k is a constant, which represents 60% of the selected period
is the moving average period.

The constant N determines the closeness with which the dynamic tracks the index.
This indicator provides the best results when used with trend following indicators, such as the Relative Strength Index (RSI). In this, the RSI is used to provide the confirmation signal. Using the MD indicator in a trading strategy is similar to how other moving averages are used.
When the price moves above the McGinley Dynamic Indicator, it may be a good time to buy. In the example provided below, the RSI line should also be over 50. The stop loss signal can be placed near the swing low. When the price moves around 50 pips over the entry price, it can be a good time to exit the trade.
When the price drops below the MDI, it can be an indication to sell. The RSI line should also be moving below 50 at this point. The stop loss can be placed close to the swing high. You can exit the trade when the price reaches 50 pips lower than the entry price.
It is important to remember that historical data is used by MDI for its calculation. It can give reliable signals as long as the trends develop in the same manner. Therefore, it is important to remember that it is an indicator and not a foolproof tool. Having said that, it is one of the most reliable indicators for the crypto markets, known for their high volatility.
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