The moving average and stochastic oscillator can both be used separately to identify the direction a currency pair is trending. However, when used alone, they can produce too many false signals. If we combine these popular forex trading indicators together then we can time our entry into the market and improve the probability of our trades. That being said, I would also keep a keen eye on price action and make sure that I have good forex money management along with trading discipline. These are all factors that can have a major impact on results when using the moving average and stochastic strategy.
What is the moving average?
If you have any trading experience, then you would have come across the moving average indicator. This is one of the most popular trading tools for conducting technical analysis, specifically for clarifying in which direction the market is heading. Whilst some of you may be able to look at a naked forex chart and determine the direction, using a single or double moving average can help to make the forex market picture a while lot clearer.
The problem is, whilst the MA can do a good job of telling you if price is going up or down, it is not great for timing trades. Hence, that is why we include the stochastic oscillator as part of this forex strategy. This way we not only have double confirmation of the trend direction, but we can also time our entry using a pullback into the trend.
You can use multiple moving averages to determine the trend using different periods but I find that too many can be more confusing than helpful. Longer period moving averages tend to be more reliable in my experience but can also be lagging. Shorter period moving averages might catch a trend quicker but can also have too much market noise and therefore more bad signals.
What is the stochastic oscillator?
The stochastic oscillator can also be good for identifying forex market trends but it also considers trend momentum. A stochastic crossover can signal the start of a new trend whereas price above the 80 level of the stochastic shows an overbought market and price below the 20 level shows an oversold market. Stochastic divergence can also confirm trend direction.
Just like the moving average, the stochastic indicator can give a lot of false signals when used on its own. I wouldn’t want to be taking a stochastic buy signal if price is below the short-term and long-term moving average. Instead, we can combine the stochastic and moving average together to make sure they both agree before taking a position in the market.
You can amend the stochastic settings from the defaults if you wish or even use double stochastics to see what the immediate and more long-term outlook on the market is. I find the stochastic indicator to be more reliable on the 1-hour charts and above. Anything less than that can contain quite a lot of market noise. Trading forex on 1-hour charts also means less time chart watching which is great.
How to trade the moving average stochastic strategy?
We will be combining all elements of the moving average and stochastic so that we can time our entry on currency pairs in line with the overall trend. We will also be looking at how price reacts around key support and resistance levels for additional confirmation. I like to use candlestick patterns as well to help form a more complete forex trading strategy. Not to mention, it is always a good idea to stay up to date with fundamental analysis such as economic news releases.
- Price is above the 200 moving average
- Stochastic (5, 3, 3) main line crosses above signal line
- Stochastic (5, 3, 3) is oversold below 20
- Bullish price action
In the GBP/USD 4-hour chart below, you will see that all of the conditions have been met for a moving average and stochastic buy trade. The currency pair price is above the 200 moving average showing we are in a strong uptrend. The stochastic main line has crossed the signal line below 20 and therefore in the oversold zone. We also have a large engulfing candlestick to the upside which is a strong bullish signal. The stop loss could have been placed just below the recent swing low. This would have been around 20 pips which is not bad when you consider price moved around 1,000 pips during this uptrend. There were numerous entry points on the way up as the stochastic crossover happened again and again, but it would have been great to get in this early.
- Price is below the 200 moving average
- Stochastic (5, 3, 3) main line crosses below signal line
- Stochastic (5, 3, 3) is overbought above 80
- Bearish price action
You can see in the GBP/USD 4-hour chart below that all of the conditions are in place for a strong stochastic and moving average sell trade. The market price is below the 200 MA and the stochastic crossover has happened downwards close to the overbought zone. We can see price has formed and tested a resistance level which is holding up. There is a hanging man candlestick which signals the sellers are winning the battle which could have been the entry point into this particular downtrend. We could have placed the stop loss just above the resistance level which would have been approximately 30 pips. The price then went down for over 1,500 pips in around 1 month, giving ample opportunity to take profits along the way. See if you can spot the multiple entry points using the stochastic crossover on the way down. Whilst it would have been great to get in at the start, sometimes it is not bad to hold fire and wait for the move to play out. However, try not to get in too late as you might end up selling low.
Moving average and stochastic strategy Pros & Cons
- Get into market trends early
- Time entry and exit
- Any currency pair and timeframe
- Combine with any other indicator
- Moving average and stochastic free to use
- Requires further confirmation
- Need sensible money management
- Will still be false signals
- Takes time to master
Conclusion: is the moving average and stochastic strategy worth trading?
As you can see from the example that I have shared here, the moving average and stochastic strategy can be very powerful when implemented correctly. We are able to catch big market moves from the start and trade with a favourable risk to reward ratio which means that one bad trade should not cancel out multiple wins. However, as with all forex strategies, it does require good forex money management, trading discipline and psychology. Otherwise, you might not get the results that you expect.
If you think the moving average and stochastic strategy is something that you would like to try, you could always test it out on a demo account to see how things go. You can get a free forex demo account from most forex brokers, including IC Markets who have tight spreads and low fees for trading forex manually or using forex robots. I would always practice any forex strategy on demo at first in order to understand how it works and see if it produces the desired results before making any financial commitment.
Self-confessed Forex Geek spending my days researching and testing everything forex related. I have many years of experience in the forex industry having reviewed thousands of forex robots, brokers, strategies, courses and more. I share my knowledge with you for free to help you learn more about the crazy world of forex trading! Read more about me.