Stochastic and MACD Strategy

The stochastic oscillator and MACD are two of the most popular technical indicators for trading forex. They can both do a great job of identifying the trend direction and momentum individually. Therefore, by combing them together we can confirm our buy and sell signals rather than relying on one or the other. If we add price action analysis into the mix and have sensible forex money management, then we have the solid foundations for a powerful stochastic and MACD strategy.

What is the stochastic oscillator?

The stochastic oscillator is a range-bound indicator, meaning that it is always fluctuating between 0 and 100. This helps to make it a useful indicator of overbought and oversold forex market conditions. Generally, stochastic readings above 80 are considered in the overbought range, and readings that fall below 20 are considered oversold.

The stochastic indicator also has two lines, the main line and signal line. When the main line is above the signal line, the market is probably moving in an upwards direction. If the main line is below the signal line then the market is probably moving down. If the stochastic crossover happens in an extreme zone, it can be a strong indication that the market is turning around.

You can adjust the stochastic settings depending on your trading style. The default setting for the stochastic oscillator is 14 periods, which can be days, weeks, months or an intraday timeframe. A 14-period %K would use the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods. %D is a 3-day simple moving average of %K.

What is the MACD?

The moving average convergence divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The standard settings for the MACD are (12, 26, 9). This refers to the difference between the 12-period exponentially weighted average (EMA) or ‘fast line’ and the 26-period EMA or ‘slow line’. The 9 period EMA of the MACD line, is known as the ‘signal line’.

If the MACD histogram crosses above the signal line or zero line, it is considered a bullish signal. Likewise, a MACD crossover below the signal or zero line is a bearish indicator. We can also use MACD divergence to gauge the momentum of a trend.

Divergence can be classified into two parts, negative and positive. Negative divergence is when the currency price moves higher, but the indicator indicates otherwise. In this case, it is moving downwards. On the other hand, when the currency price moves downwards, the indicator shows a higher point. This is an essential aspect of trading as it can help to identify the possibility of a trend reversal.

How to trade the stochastic and MACD strategy?

You can combine all of the important aspects of the stochastic and MACD indicators to look for buying and selling signals on all of your favourite currency pairs and chart timeframes. You can use this strategy for scalping, day trading and swing trading if you wish.

I like to trade the 1-hour forex charts and above as I find they help to filter out some of the market noise from the lower term chart timeframes. I also prefer to trade major currency pairs such as the EUR/USD and GBP/USD as they often have plenty of liquidity which means that we can catch some good market moves and trade with low spreads and rapid trade execution speeds, especially if using an ECN forex broker.

Buy signal

  • MACD (12, 26, 9) histogram above signal line
  • Stochastic (5, 3, 3) is around oversold zone (20)
  • Stochastic (5, 3, 3) main line crosses above signal line
  • MACD and stochastic divergence to the upside
  • Price bouncing from support or breaching resistance
  • Bullish price action

You can see in the EUR/USD 1-hour chart below that all of the conditions have been met for a buy trade based on the MACD and stochastic strategy. We have a support level formed that is holding up well and price has started to move away from it. The MACD histogram has crossed above the signal line. The stochastic main line has also crossed above the signal line and is in the oversold area suggesting we will see a reversal to the upside. There is MACD and stochastic divergence confirming the move. We initially had some market indecision around the support level as evident with multiple doji candlestick patterns. However, the buyers won the race in the end as you can see from the large green engulfing bar. The stop loss could have been placed just below the support level which is around 20 pips. This EUR/USD uptrend continued for at least 700 pips over the space of a week which gave as ample opportunity to take profits. You will see that there were multiple entries based on the stochastic crossover on the way up, but getting in at the start would have been ideal.

Stochastic MACD Strategy Buy Signal
Stochastic MACD Strategy Buy Signal

Sell signal

  • MACD (12, 26, 9) histogram below signal line
  • Stochastic (5, 3, 3) is around overbought zone (80)
  • Stochastic (5, 3, 3) main line crosses below signal line
  • MACD and stochastic divergence to the downside
  • Price bouncing from resistance or breaching support
  • Bearish price action

In the EUR/USD 1-hour chart below, you can see that we have all the conditions for a sell trade based on the stochastic and MACD strategy. The price has formed and tested a resistance level which has held up well. Price is now falling which is confirmed by the MACD crossing the signal line and the stochastic main line crossing the signal line around the overbought zone. There is divergence to the downside and a hanging man candlestick pattern to confirm entry. We could have placed the stop loss just above the resistance which is around 25 pips. Not bad when you consider this EUR/USD downtrend continued for over 430 pips. Again, there are a few re-entry points on the way down based on the stochastic crossover. I would have wanted to lock in this trade at break-even point and trailed the remaining of the position using a trailing stop loss to get the most out of the move.

Stochastic MACD Strategy Sell Signal
Stochastic MACD Strategy Sell Signal

Stochastic MACD strategy Pros & Cons

Pros

  • Catch some big market trends
  • Indicators complement each other well
  • Can use with any other technical indicators
  • Can use on any currency pair and chart timeframe
  • Actionable buy and sell signals
  • MACD and stochastic indicators are free to use

Cons

  • Requires good entry and exit timing
  • Needs good discipline and money management
  • Can take some time to master
  • There will still be false signals

MACD vs Stochastic

I think the MACD and stochastic indicators can both do a good job at spotting the trend direction and gauging the momentum. Both can also be very useful at spotting the start and end of trends. I actually prefer the stochastic for timing my entry on the crossover around the extreme levels but will always reference the MACD to make sure it agrees with the signal. Hence, they complement each other well compared to being used separately.

Conclusion: is the stochastic and MACD strategy any good?

Yes, as you can see from the EUR/USD trade examples that I have shown on this page, trading forex with the stochastic and MACD strategy can allow us to catch some big market moves. If you implement it correctly, you can get into trends early and make the most of each move. However, it does require some user initiative and as with any forex strategy, there will still be false signals. This is why I would use further price action and fundamental analysis to confirm each position.

If you think that the stochastic and MACD 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 are one of my best forex brokers for manual and automated forex trading systems. I would always practice any forex strategy on demo at first in order to understand how it works and see if it produces good results before making any commitment.

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